Pictet Asset Management - The trouble with bonds

Pictet Asset Management - The trouble with bonds

Why an allocation to unconstrained fixed income strategies makes sense for investors.

by Patricia Schuetz, Senior Client Portfolio Manager

Bond investors could be forgiven for feeling a little disoriented. After a decade of ultra-low rates and negative yields, inflation is suddenly on the rise. 

Uncertainty abounds – over the pace of monetary tightening in different countries, the persistence or otherwise of inflationary pressures, and the evolution of the Covid-19 pandemic.

The notion that government bond markets are oases of calm has consequently been consigned to history. Lockdowns eased after new vaccines offered an exit from the pandemic and the resumption of economic growth. But the ‘return to normal’ unexpectedly led to much higher inflation (hitting 30-year highs in the US, for instance) and higher interest rates. Central bankers tried to balance their inflation-fighting credibility with assurances that policy would remain supportive. Yet bond market volatility spiked, with the MOVE index setting 20-month highs. In just three months, the yield on benchmark 10-year US Treasuries swung from a low of 1.17 per cent in August to a high of 1.70 per cent in October before trending down and then up again. While repayment of principal and interest are still assured, gone are the days of one-directional trading in government bonds. 

Investors can of course accept this new reality. They can simply resign themselves to owning a more volatile portfolio.

But there is an alternative. And it comes in the form of an unconstrained, absolute return fixed income (ARFI) strategy. Untethered from bond benchmarks, and free to deploy advanced risk management techniques, ARFI strategies are designed to deliver returns independent of the fixed income market. 

For these reasons, they can serve as a buffer for – and complement to – a traditional fixed income portfolio.

Low correlation
Daily correlation of returns between a representative segregated portfolio and key equity and FI indices

Source: Pictet Asset Management as of 29.10.2021. Base currency USD, performance above one year is annualised.
Source: Pictet Asset Management as of 29.10.2021. Base currency USD, performance above one year is annualised.

Typically, ARFI funds target a specific level of return over a specific time frame, expressed as a percentage point gain over a commercial lending rate or inflation.

To the investment managers running the ARFI strategies at Pictet Asset Management, delivering on this goal requires a multi-faceted approach to portfolio construction.

First, the investment universe needs to be broad. Investments should be chosen from the widest possible range of easily-tradeable bonds, currencies and derivatives. This makes it easier to construct a diversified portfolio composed of assets whose returns don’t move in tandem.

Second, more attention should be paid to the structural trends that influence bond returns than cyclical, and more volatile, factors such as economic growth and inflation.

Third, every investment idea must have a buffer in place to ensure the most favourable trade-off between risk and prospective return, particularly when developments don’t unfold as planned.

The essential elements of absolute return fixed income

1. Looking beyond benchmarks

In many cases, there's little to distinguish long-only, actively managed portfolios from their passive counterparts. They are almost equally susceptible to the shifts in the broader market. As recent experience shows, sudden moves in interest rate expectations or significant changes in benchmark composition hurt index-trackers and
long-only active portfolios alike. 

Take the current situation in Turkey. Conventional wisdom dictates that sustained increases in inflation warrants tighter monetary policy. In Turkey’s case, intervention by the country’s president not only led to interest rate cuts instead of hikes, but also to a complete change of the central bank’s monetary policy committee when its members disagreed with him.

Similarly, the inclusion of China in the FTSE WGBI in October 2021 forced investors to buy Chinese government bonds merely to stay neutral to their reference benchmarks, regardless of their views on the country. Because they are unconstrained and not tied to an index, ARFI strategies can avoid such risks.  

A distinguishing feature of ARFI strategies is that they are not overly reliant on any one source of return. They harvest returns from changes in interest rates (duration), issuer creditworthiness (credit premia) and currencies. Investments are sourced from the broadest possible range of tradable securities globally. Emerging market bonds
and currencies, investment and non-investment grade bonds, and other credit instruments such as credit default swaps are part of the investment mix. 

In diversifying sources of risk and return in this way, ARFI strategies are better able to generate gains across all phases of the economic and financial cycle, which means their inclusion within a fixed income allocation can potentially improve volatility-adjusted returns.

2. Looking beyond the economic cycle

Many bond investors spend a lot of time and effort attempting to forecast future economic conditions. Yet such predictions are rarely accurate. In late 2019, for example, economists were forecasting a respectable 2.7 per cent growth for the following year.  Then the pandemic hit, countries locked down and, in the end, global GDP contracted by 3.4 per cent in 2020.  Of course, no one could have predicted Covid, though, but forecasts continue to be proved wrong, not least by the extent of the supply bottlenecks and the resulting inflation pressures.

Even stripping out extreme events, such as the pandemic, each business cycle is invariably different from the one before. Radical changes in the political landscape – like Brexit and the rise of populism in Europe and the US – can up-end economic models. And then there’s the knotty problem of distinguishing cause from effect in any
statistical analysis.

An alternative strategy is to look beyond the business cycle and focus on the long-term structural changes in the economy and markets.

PictetAM's ARFI team has built its portfolio around three long-term trends:

  • Low rates for long. Even before the pandemic, global economic growth and productivity was lacklustre, with governments facing an uphill struggle to reduce public debt. The need for quick and aggressive fiscal spending to control the pandemic and keep the economy afloat through lockdowns and restrictions added to that debt pile. As economies reopened, prices surged. All of which means high public debt levels are unlikely to shrink significantly any time soon. So the
    inflation surge should prove transitory. And even in the event that interest rates do need to rise, ‘financial repression’ – deliberately keeping monetary policy loose in the face of rising inflation to contain debt servicing costs – should prevail.  This means real interest rates are likely to remain at low levels for some time. 
  • Euro zone’s challenges. The financial crisis led the euro zone to create a common fiscal pool of funds while the pandemic saw the issuance of EU-wide bonds. These are significant changes in the financial and political make-up of the union. But more
    reform is needed, including the establishment of a common banking union and a fiscal transfer mechanism under which the public debts of euro zone members are pooled and supported. Yet given the politically-charged environment in which decisions are taken, such changes will take time. Germany has a new coalition government, France faces elections, the true economic impact of Brexit remains unclear, and the resignation of the well-respected hawkish voice, and longest serving member, of the ECB’s governing council, Bundesbank President Jens Weidmann, adds more uncertainty. We believe these developments present as many investment opportunities as risks. 
  • Economic and financial transformation in China. China’s sweeping reforms and regulations are aimed at building a diverse and stable economy, with increasingly open and sophisticated capital markets. Capital market liberalisation and the expansion of the country's local bond market will transform global financial markets, with far-reaching consequences for countries in the developed and emerging world. However, it won’t be smooth sailing, as evidenced by recent crackdowns in the technology and real estate industries.

3. Controlling risk at every stage of the investment process

The changes in the economic and political landscape, and their effects on the fixed market, make bond investing more risky. PictetAM's ARFI team has devised a process that seeks to contain such risks at every stage.

On one level, this involves taking great care to avoid over-exposing the portfolio to any one investment theme, idea or source of return.

On another, it means ensuring investment strategies are expressed in a way that offers the most efficient trade-off between risk and return. Scenario-based portfolio construction is critical to meeting these goals.

Lower drawdowns

Cumulative drawdown for Pictet Absolute Return Fixed Income and selected broad fixed income indices                          

Source: Barclays Indices, Pictet Asset Management. Data as of 29.10.2021.
Source: Barclays Indices, Pictet Asset Management. Data as of 29.10.2021.

a. Diversification by source of return.Investing across a broad range of developed and emerging fixed income asset classes gives investors access to a number of potential sources of return. Pictet AM's ARFI strategy aims to secure returns from three main sources: 

  • Interest rates
  • Credit premia 
  • Currency

We recognise that each of these is also a potential source of risk, and ensure the portfolio’s risk budget is equally distributed across all three.

b. Diversification by investment theme and risk scenario. With this in mind, the team makes sure that all its investment ideas are evenly represented in the portfolio. Neither does the team favour one economic forecast over another. Rather, it seeks to balance one scenario against another. This distinguishes PictetAM's approach from those of strategic bond funds or active benchmark-oriented portfolios. The former tend to concentrate investments in high-conviction ideas, while the latter do not usually venture far beyond the boundaries of their reference index.

c. Efficient implementation of investment ideas. By embracing a broad investment universe, our portfolio managers give themselves options. Often, they find they're able to express a particular investment view in several ways.

This means they can compare alternatives and choose the most efficient. For instance, there are many investments that could perform well if inflation pressures prove transient and stagflation is avoided. To this end, we see potential in the intermediate part of the curve (5 and 10 year maturities) in the US and in Germany, and also have exposure to peripheral Europe.

But there's also a risk-mitigation element to the process. The team also seeks out an offsetting investment to contain any unwanted volatility.

The aim to here is to protect the portfolio should the team's thesis fail to play out as expected. It is an insurance policy. 

For example, central banks in some countries – such as the UK and Poland – may have more of a credibility issue when it comes to bringing inflation under control. The risk can be mitigated through taking short positions on their currencies or bonds.

3. Stress testing and risk oversight

Diversification of positioning is critical to controlling risk in the portfolio, while monitoring the correlations of portfolio investments is key to maintaining that diversification. The team not only stress tests the portfolio’s performance under different one-off shock
scenarios, but also on an on-going basis across the alpha sources, investment themes and risk scenarios. This continuous monitoring is key to controlling risk.

The end result, we believe is a more balanced bond portfolio.

Bonds have historically provided investors with steady capital returns and reliable streams of income. Yet the structural trends unfolding in the fixed income market have changed this dynamic. Not only are a large proportion of government and corporate bonds still offering very low or negative yields, but as market liquidity has diminished over the years, the fixed income asset classes that make up the market are more in sync with one another than they have been historically.              

Investors looking to build and maintain diversified portfolios should consequently modify their approach. By allocating some capital to strategies that aim to deliver attractive returns irrespective of market conditions, investors have the opportunity to build more resilient fixed income portfolios.

Press contacts:

Olivier Duquaine
Olivier Duquaine Managing Director, Backstage Communication

About Pictet Group

The Pictet Group is a partnership of seven owner-managers, with principles of succession and transmission of ownership that have remained unchanged since foundation in 1805. It offers only wealth management, asset management, alternative investment solutions and related asset services. The Group does not engage in investment banking, nor does it extend commercial loans. With CHF 609 (USD 689, EUR 563, GBP 504) billion in assets under management or custody at 31 December 2020, Pictet is today one of the leading Europe-based independent wealth and asset managers for private clients and institutional investors.

Headquartered in Geneva, Switzerland, and founded there, Pictet today employs around 4,900 people. It has 30 offices worldwide, in Amsterdam, Barcelona, Basel, Brussels, Dubai, Frankfurt, Geneva, Hong Kong, Lausanne, London, Luxembourg, Madrid, Milan, Monaco, Montreal, Munich, Nassau, New York, Osaka, Paris, Rome, Shanghai, Singapore, Stuttgart, Taipei, Tel Aviv, Tokyo, Turin, Verona and Zurich.


Pictet Group
Banque Pictet & Cie SA
Route des Acacias 60
1211 Geneva 73 - Switzerland