Absolute Returns: Fixed income investing

As investors are faced with the twin spectres of short-term deflation and long-term inflation, long only fixed income managers face a difficult environment.

In such a situation we believe that an absolute return approach to fixed income investing could be worth considering.

Although the first three months of 2009 saw a continuation of the financial turmoil that had overshadowed global markets for much of 2008, there were some remarkable developments. Unprecedented state intervention and a further deterioration in the economic environment outside of the financial sector saw the macroeconomic debate move from discussions of conventional strategies to more elaborate plans and fiscal stimulus packages.

With official interest rates already close to zero in some countries, quantitative easing appears to have become the policy du jour of many developed central banks.

The poor economic news and the response of governments across the globe resulted in a volatile three months for government bond markets. Initially, global bond markets weakened, as increased levels of fiscal and monetary stimulus prompted supply concerns. However, some of these losses were subsequently recovered as the focus shifted back to the poor state of the global economy and the recession bedevilling many countries.

Gloomy economic outlook

At the time of writing, the economic outlook is almost unremittingly gloomy, with the major Western economies mired in recession. Financial authorities around the world have cut interest rates aggressively and pledged to support the financial system with remarkable amounts of money. Despite this, there are still strains on the financial system and the supply of credit remains restricted.

Whilst the yields on government bonds make them look poor value at current levels, the short-term outlook is relatively positive given heavy central bank buying. Inflation is, as ever, the main risk to bond markets but, with the near-term threat to the economy now coming from the withdrawal of confidence, governments are now more concerned about the risk to growth and the possibility of deflation rather than the threat of inflation.

Response may be storing up problems for the future

Taking a long-term view, the problem for bond investors will be that government borrowing is ultimately going to have to pay for the measures being introduced by politicians in their attempt to avert depression. This raises the prospect of massive supply of government bonds, with inevitable upward pressure on yields. So far, bond yields have remained low, with short-term rates lower than long-term but, if recent policy measures are successful in boosting economic activity, bond investors will quickly focus again on the risk of inflation.

Growth and inflation could surprise on the upside

Looking out over the medium term, given the policy response of the authorities globally and the amount of bad news already reflected by markets, we believe the major risk is that growth and inflation prove stronger than expected. If policy-makers are slow to withdraw their accommodative monetary policy, they could easily re-ignite inflation and cause an inflation shock.

Volatility likely to persist

Another factor complicating the outlook is that we expect volatility to remain elevated for some time. The credit shock has elicited an aggressive policy response globally and, going forward, imbalances and differential policy responses between countries could constitute a source of additional shocks. Furthermore, the credit crunch will probably trigger some form of re-regulation aimed at controlling system-wide leverage and this could permanently reduce the liquidity of some assets. It is reasonable to assume that the combination of more frequent shocks and reduced liquidity could exacerbate volatility in asset prices.

Long-only fixed income fund managers have a difficult time ahead

By any measure, bond investors face uncertain times, as sentiment oscillates between the spectre of depression and, in our view, the more realistic scenario of a return of inflation. Given the huge amounts of money being pumped into the system to support stricken financial institutions, we expect the money supply - the root cause of inflation - to increase, and this will exert significant downward pressure on bond prices. Of course, increasing exposure to inflation-linked securities and careful positioning on the yield curve can help to protect portfolios in this environment. However, the fact of the matter is that traditional long-only fixed income fund managers have limited tools at their disposal in an environment of sharply rising yields.

So what sort of strategies should fixed income investors be considering? One solution for anyone concerned about the prospects for markets would be to consider a product which aims to deliver positive returns in all investment conditions. The Baring Absolute Return Global Bond Trust, which I manage, is designed to generate absolute returns under all market backgrounds, uncorrelated to the returns from other asset classes.

The merits of absolute return investing

As the name indicates, the aim of investing for an absolute return is to make money under all market conditions. In practice, this means that when selecting the securities to be held in our portfolio we aim to be on the right side of moves in the fixed income government bond and currency markets. The trust can be "long" of markets and currencies when they are rising and, importantly, has the ability to be "short" of markets and currencies when they are falling, creating the potential to profit from falls in markets and currencies. Taking short positions has been on the receiving end of some very bad press in the recent past. However, properly used, it is actually a very useful process, enabling unit holders to profit when fund managers correctly identify overvalued securities, whether they are equities, bonds or currencies.

In this volatile investment environment, our key message is choose your bond manager with care and be mindful that their style and process are key factors which will determine their performance. I believe our active approach with its strong contrarian style is ideally suited to the current volatile market conditions. Although our process may deliver periods of negative performance over short periods, our disciplined and phased approach to position building is designed to ensure that any such periods should be more than compensated for by periods of positive performance.

Colin Harte is investment manager at Baring Absolute Return Global Bond Trust