The single most common question we have been asked at adviser group investment committees over the past 18 months has been, “What should I do with my clients’ defensive or fixed interest exposure?”
With Australian and global bond yields at historically low levels and term deposit rates having declined materially in line with the Reserve Bank of Australia’s (RBA) cuts in official interest rates, it is a relevant question. In addition, the potential for bond yields to rise (and bond prices to fall) as interest rates revert to more normal levels, and result in significant capital loss is a major concern.
So what have fund managers done?
These challenging bond market conditions have led many managers to develop solutions that accommodate a rising bond yield environment for investors. These solutions have resulted in the launch of a number of unconstrained and absolute return fixed interest funds, particularly the former where numerous funds have been launched. As the majority of these funds are very new, there is a lack of understanding and confusion around what these funds are designed to do and where they fit in a portfolio.
Many advisers are viewing both styles of products as ‘absolute return’ funds, that will provide positive returns through all market cycles. While it’s true these products provide much more flexible mandates to enable managers to protect portfolios and generate investment returns in a rising yield environment, unconstrained bond funds will not always provide investors with positive returns.
Where do these new funds fit in a portfolio?
Perhaps an easier way to view both absolute return and unconstrained bond funds is that both are ‘total return’ focussed. This means that the level of income produced will be an output of the investment process, rather than a target. The objective is to protect capital and maximise total return. This may not suit those investors seeking regular, predictable income from their bond fund investments.
Nonetheless, the aim of some (not all) of these funds is to continue to provide investors with exposure to fixed interest markets, with the flexibility to use short selling and other hedging techniques to protect capital and / or generate investment returns in a rising interest rate environment.
These features, combined with the funds’ potentially lower levels of correlation with ‘traditional’ bond funds, means that they can represent an excellent diversifier for the defensive exposure of portfolios.
