Will absolute-return bond funds protect you from bond volatility?

Getting out of bonds

Bonds are having a torrid time of it. Volatility in global government bonds has spiked to new highs in recent weeks on the back of diverging central bank policy and investor fears that rate rises will wipe the value off long-dated debt.

Last week Mario Draghi, president of the European Central Bank (ECB), caused a further selling frenzy by telling markets that they should get used to fixed-interest volatility in an era of ultra-low interest rates. Yields on benchmark eurozone sovereign debt rose to their highest level this year and prices - which move inversely to yields - crashed in the latest bout of instability since the launch of the mass quantitative easing (QE) programme earlier this year.

Adrian Lowcock, head of investing at AXA Wealth, says: "Investors need to be cautious with their exposure to the bond market - after a three-year bull run and record low interest rates it has become more difficult to get decent interest: the risks of achieving a 5 per cent return, once the expected normal yield, have risen fourfold following the financial crisis. Bonds are no longer the lower-risk asset class and investors could lose significant sums of money."

Alternative bond funds: Should you invest?

If you want to retain exposure to bonds but reduce the risk of the asset class you could look to absolute-return bond funds, which aim to deliver positive returns year on year, regardless of market conditions.

The funds use derivative instruments to run short and long trades in order to generate specific return goals throughout market cycles. Some funds aim to generate a real return above inflation, while others aim just to deliver positive returns year on year. Many also have added risk protection measures in place, such as placing fund money in separate 'buckets' with varying risk controls to protect capital. However,, they can be risky, too, as they use gearing and derivatives to achieve their aims.

The drawbacks

The sector is controversial, with many funds in it having failed to generate the steady returns they target in recent years. The key risk with investing in absolute-return bond funds lies in the complexity of the processes used to generate return. Absolute-return managers use a wider set of instruments, including derivates and hedges, than traditional fund managers are allowed to. It means they are able to hedge out certain portfolio risks, but also that they take multiple bets in the same portfolio which they may not always get right.

Mr Lowcock says: "You are buying the decision-making process of the manager and his ability to get his calls right. With a traditional bond fund manager, the risk is around whether he is buying the right bonds at the right time of the market. With absolute-return funds you are getting that decision-making skill multiplied. You are asking if he can sell the right bonds, but also if he can get the right protection in the portfolio. There are a lot more tools that an absolute-return manager can use and you are relying on them to use those tools correctly."

He adds: "An absolute-return fund can make money in volatile markets because its managers have more tools at their disposal."

But many experts are unconvinced by the sector as a whole and are steering clear, instead turning some of their bond exposure to cash as a protective measure or opting for strategic bond funds, which can be more nimble than traditional funds in switching between bond assets. Martin Bamford, chartered financial planner and managing director at Informed Choice, says: "The sector hasn't covered itself in glory in recent years. I think you would have wanted to see some consistency in returns exceeding inflation and charges, and I just think that hasn't been proved on average."

Patrick Connolly, certified financial planner at Chase de Vere, says: "I'm sceptical that they will do what they say on the tin - better than cash - and a lot of them have performance fees attached which they earn for beating very minimal targets, for example for beating Libor rates, and most cash funds would do that."

If you are an income seeker, these are not for you, either. They do not target yield and so do not deliver high income levels like other fixed-income funds can.

How convincing are the options?

Absolute-return funds are not designed to shoot the lights out in rising markets but to protect against downside crashes, and many have delivered consistent returns year on year. Both Mr Hollands and Mr Lowcock like Kames Absolute Return Bond B Acc (IE00B6SPX874), which has delivered a positive return in 32 months out of 43. Mr Lowcock says: "Kames Absolute Return Bond Fund has been a consistent performer and isn't as volatile as some of its peers. Manager Colin Finlayson is looking to get a positive absolute return over the past three years. The manager can invest anywhere in the global bond market, including floating rate notes. The fund is a low-risk bond fund designed to minimise volatility and protect against loss."

According to Investment Association data, the fund has succeeded in delivering returns greater than zero after charges for 24 rolling 12-month periods. It sets out to generate positive absolute returns for investors over rolling three-year periods irrespective of market conditions. It generates market return from asset allocation, trades based on differing interest rates across markets, and buying and holding short-dated investment-grade bonds to maturity at profit.

Due in part to the fund's popularity, Kames has also just launched the Kames Absolute Return Bond Global Fund and Kames Absolute Return Bond Constrained Fund, to meet expected demand and to divert flows away from the existing fund.

Kames has stopped actively marketing its Absolute Return Bond Fund due to capacity constraints, as it is near £2bn assets under management.

Mr Hollands also likes Absolute Insight Credit B1p2 (IE00B4K9SV11), which targets at least three-month London Interbank bid rate (Libid) + 5 per cent on a rolling annualised five-year basis gross of fees and expenses. It invests in asset-backed securities and credit default swaps, as well as bonds, and in the past three years has performed well. However, it suffered in 2011, when total returns fell by -0.77 per cent. The fund charges a performance fee of 20 per cent per year of any returns it achieves above its benchmark, which is three-month Libid (the amount at which banks are prepared to borrow from other banks) and has achieved that target over three and five years annualised.

Mr Connolly likes Newton Global Dynamic Bond W Acc (GB00B8H50V47) and Schroder Absolute Return Bond A Acc (GB0007905945). Neither fund has a performance fee and both carry similar ongoing charges. Newton Global Dynamic Bond fund invests in a mixture of higher-yielding corporate and government fixed interest.

It has delivered positive returns for the past 10 years and aims to deliver a minimum return of cash (1-month GBP Libor) plus 2 per cent a year over five years before fees. It also targets a positive return each year on a rolling three-year basis. In recent months, taking a short position on futures contracts of five-year US Treasuries proved to be a bad call and cost the fund returns.

Schroder Absolute Return Bond Fund targets a lower threshold, aiming to achieve returns over three-month Libor. However,, in April the fund delivered negative returns, partly due to exposure to sterling corporate bonds, which fell in value over the month, and several of its currency positions.

Of the funds mentioned it has delivered some of the lowest returns in the past four years, falling by 2.87 per cent in 2011. However,, it is able to invest globally and across the full spectrum of fixed-interest securities, making it highly flexible.

Henderson Credit Alpha I Acc (GB00B1XDHW32) offers exposure to corporate credit, taking positions in credit default swaps and corporate bonds. The fund looks at high-grade and high-yield debt, hedging currency risk and interest rate risk using forwards and futures. It carries a performance fee of 20 per cent of net performance over Libor meaning that if over three months, the fund has returned more than Libor, one-fifth of the difference in performance will be charged as a fee. However, the manager cannot be rewarded for the same performance twice - known as a high water mark.

How much of your portfolio should you dedicate to protection?

Advisers say you should think of absolute-return bond funds as part of a chunk of your portfolio dedicated to protecting capital, rather than as an alternative to bonds.

Mr Lowcock says: "Typically you would have around 10 per cent in some sort of hedging, absolute return or protection, but my concern at the moment is that lots of things are expensive and even the cheaper areas are a lot less cheap than they were. So you're probably better off having up to 20 per cent in protection and absolute return now. It does depend how much risk you want, but the key with investing is protecting your capital first.

"Absolute-return bond funds address both the bond fund and protection chunk of your portfolio. In that sense, getting up to 20 per cent is a lot easier, because, for example, you could have 10 per cent of your protection in traditional absolute-return strategies, which might include equities, and 10 per cent of your portfolio in defensive bond strategies."

However,, other advisers say they do not like absolute-return bond funds and would prefer to diversify bond portfolios by holding strategic bond funds, and protect capital by turning to cash.

Mr Connolly says: "We're generally quite sceptical about the sector as a whole. Some funds have done well in recent years, but so have equities. We haven't had a period yet where we've seen fixed income go into freefall, so it's hard to know how they will perform when that happens."

Funds and targets

Source: Provider factsheets

Funds and discrete annual calendar total return (%)

Source: FE Trustnet, as at 5 June 2015