One would expect TIM HAYWOOD, the chief investment officer of post-MBO spin-off from Julius Baer, Augustus Asset Managers, to talk up the prospects for absolute return funds. However in the following article he compares the characteristics of absolute return to those of each ‘traditional’ asset class, as well as the total return funds with which they are sometimes confused, to more specifically make his case.

Absolute return funds will acquit themselves better than Australian Commonwealth Government Bonds (ACGBs), corporate bond funds, total return funds, low volatility fund of hedge funds and deposit accounts in most cases.

Bonds could easily disappoint

With a steeply inverted yield curve – 15 year ACGBs yield 6 per cent (which is 1.5 per cent less than nominal GDP) while the Reserve Bank Of Australia’s cash target rate stands at 6.75 per cent – and a real yield on 10 year inflation-linked debt of only 2.5 per cent, traditional domestic bond portfolios offer a potentially poor source of both returns and inflation protection in the medium term.

If the RBA holds rates steady for a long period, bonds will rise in yield and fall in price. If inflation is less than 3.4 per cent over the next ten years, inflation-linked debt will underperform.

Keeping Poor Company?

Corporate bond funds have ridden the wave of credit spread contraction. Now, credit markets are proving to be more volatile. Trading in corporate debt is currently somewhat irksome.

Estimates of fair value in high grade and high yield markets do not yet reveal notable value relative to current spreads. Predicting the future balance sheets has never been so tricky: many companies change fiscal shape, or have their shape changed for them, before the term of their latest bond issues. To claim to always know better than others the future shape of a company is to risk counterclaims of insider trading!

Finally, lending money to companies in the very short term has heightened reinvestment risk without eliminating the default risk. Look at the profile of corporate bonds with low yields: they have limited upside as redemption nears yet far greater downside in the event of default, downgrade or unprotected change of control.

Shorting credit, where the specific risk / return looks compelling, makes intuitive sense, whereas shorting stocks has unlimited downside and limited upside.

Absolutely better, totally worse

So-called ‘total return’ describes a mandate type which is typically permanently long both duration and (primarily domestic US) credit exposure. This means that funds will struggle when yields rise, and will suffer when credit spreads widen.

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