Absolute return bond: thriving in volatility

Absolute return bond strategies are designed to deliver a positive return in all environments. In an era characterised by high volatility, Insight Investment¹ portfolio managers Harvey Bradley and Shaun Casey explain how they can be used by those seeking a mixture of stable growth and capital preservation.

How do absolute return bond strategies smooth out volatility?

 A fully flexible approach to portfolio construction is one of the first steps in seeking to reduce volatility. This means that whenever markets are overly fearful or exuberant, a manager has the broadest choice of mispriced securities to buy or sell. It also means the freedom to go long or short on any strongly held beliefs on valuations.

Overall, it can be seen as a way of seeking to improve risk-adjusted returns from fixed income.

Over the past 12 months (to the end of March 2025) Insight’s absolute return bond strategy has experienced a fraction of the volatility experienced in government bonds or investment grade credit (see table below).

What has driven performance in 2025?

Insight’s absolute return bond strategy made most of its alpha in Q1 2025 from government bond positioning. There has been far more volatility and dislocation in prices in government bonds than in credit over the year to date. This has meant better chances to buy bonds such as US Treasuries and UK Gilts at what we see as cheap valuations.

Notable gains from the strategy have come from building long positions in US Treasuries and Gilts when they sold off sharply in January. Gains have also come from holding shorter dated government bonds on the expectation of rate cuts, while another helpful position has been taking a view that UK inflation would fall where markets were less optimistic of such an outcome.

There has been far less volatility in investment grade credit where returns have been flat. Following the ‘Liberation Day’ US tariffs announcements on 2 April, investment grade credit yields moved 10-15 basis points wider, but they tightened again by the end of April. We used the correction to reduce its risk position in credit, as the team thinks there is more risk to come from trade disruption. To protect on the downside its position is based more around relative value and sector positions than in reflecting market beta.

What assets do you own to generate attractive absolute returns?

Generally speaking, the most attractive returns in Insight’s strategy come from investment grade corporate bonds. To complement this, the strategy has an allocation to asset-backed securities which pay a premium above yields of corporate credit of the same risk rating. At the riskier end of the credit spectrum, it invests selectively in a few high yield securities and leveraged loans, where we are confident in our ability to pick issuers with resilient non-cyclical businesses and improving credit scores.

How important are derivatives to an absolute return bond strategy?

Derivatives can enable Insight to be nimble during periods of high volatility. When investors are fearful it becomes harder and more expensive to trade physical bonds, so expressing a view on markets through derivatives offers an alternative approach.

Derivatives also play a role shortly before or after a big event or announcement. Here again, it can be too cumbersome to sell a large number of bonds to express a view on markets.

A more nuanced job is to buy downside protection through an option that enables a portfolio to more confidently take on extra risk to boost returns.

The team would go so far as to say that an absolute return bond strategy that does not make full use of derivatives has less ability to protect investors from drawdowns.

How much risk do derivatives pose?

Insight treats derivatives with the same level of risk controls it would with a physical asset. As such derivatives should be no more risky than a physical asset if the risks taken are understood.

Outlook

Both 2025 and 2026 appear to hold elevated levels of uncertainty for global growth and security. The US is redefining itself on trade, geopolitics, defence and tax, but the jury is out on whether these changes will be positive for the US. There may be some positive news for companies and GDP if corporate taxes and regulation are reduced; however, these are balanced by concerns that higher tariffs will overall prove a negative for the US economy due to reduced trade and higher prices. Only hard economic data over the rest of the year will make this picture clear.

Past performance is not a guide to future performance.

The value of investments can fall. Investors may not get back the amount invested.

Key risks associated with this strategy

Geographic Concentration Risk: Where the strategy invests significantly in a single market, this may have a material impact on the value of the strategy.

Objective/Performance Risk: There is no guarantee that the strategy will achieve its objectives.

Currency Risk: This strategy invests in international markets which means it is exposed to changes in currency rates which could affect the value of the strategy.

Derivatives Risk: Derivatives are highly sensitive to changes in the value of the asset from which their value is derived. A small movement in the value of the underlying asset can cause a large movement in the value of the derivative. This can increase the sizes of losses and gains, causing the value of your investment to fluctuate. When using derivatives, the strategy can lose significantly more than the amount it has invested in derivatives.

Emerging Markets Risk: Emerging Markets have additional risks due to less-developed market practices.

Share Class Hedging Risk: For hedged share classes the hedging strategy is used to reduce the impact of exchange rate movements between the share class currency and the base currency. It may not completely achieve this due to factors such as interest rate differentials.

Counterparty Risk: The insolvency of any institutions providing services such as custody of assets or acting as a counterparty to derivatives or other contractual arrangements, may expose the strategy to financial loss.

Environmental, Social and Governance (ESG) Investment Approach Risk: The strategy follows an ESG investment approach. This means factors other than financial performance are considered as part of the investment process. This carries the risk that the strategy's performance may be negatively impacted due to restrictions placed on its exposure to certain sectors or types of investments. The approach taken may not reflect the opinions of any particular investor. In addition, in following an ESG investment approach, the strategy is dependent upon information and data from third parties (which may include providers forresearch reports, screenings, ratings and/or analysis such as index providers and consultants). Such information or data may be incomplete, inaccurate or inconsistent.

Performance Aim Risk: The performance aim is not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for returns to vary significantly.

Changes in Interest Rates & Inflation Risk: Investments in bonds/money market securities are affected by interest rates and inflation trends which may negatively affect the value of the strategy.

Credit Ratings and Unrated Securities Risk: Bonds with a low credit rating or unrated bonds have a greater risk of default. These investments may negatively affect the value of the strategy.

Credit Risk: The issuer of a security held by the strategy may not pay income or repay capital to the strategy when due.

China Interbank Bond Market and Bond Connect risk: The strategy may invest in China interbank bond market through connection between the related Mainland and Hong Kong financial infrastructure institutions. These may be subject to regulatory changes, settlement risk and quota limitations. An operational constraint such as a suspension in trading could negatively affect the strategy's ability to achieve its investment objective.

CoCo's Risk: Contingent Convertible Securities (CoCo's) convert from debt to equity when the issuer's capital drops below a pre-defined level. This may result in the security converting into equities at a discounted share price, the value of the security being written down, temporarily or permanently, and/or coupon payments ceasing or being deferred.

A complete description of risk factors is set out in the Prospectus in the section entitled "Risk Factors".

¹Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Management (Luxembourg) S.A. (BNY MFML) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA, BNY MFML or the BNY Mellon funds.
 

2537859 Exp: 16 January 2025