Central banks’ attempts to sustain the global recovery have left many bond investors in a tricky position. With rates at extreme lows, there is little room for further declines and consequently less opportunity for bond investors to achieve capital gains. Unless the economy slips back into recession, yields should move up in the next year or so, leading to capital declines in fixed-income strategies managed against major indexes.

The difficulty this presents to bond investors may be long lasting. After three decades of broadly declining yields, some people think we may be at — or even beyond — an inflexion point in the long-term interest rate cycle. If so, investing relative to a fixed-income bench- -mark could become less desirable for years to come.

A compelling proposition?

The interest rate outlook has thrown the spotlight on absolute-return fixed-income strategies, which target a positive return in all market environments — that is, irrespective of whether indexes are rising or falling.

For investors buffeted by market fluctuations in recent years, the case for absolute return might appear compelling even without the prospect of rising rates. With some big systemic risks still overhanging the economy — among them Europe’s sovereign debt troubles, overheating risks in the emerging world, and the fragility of the recovery in some of the major industrialized nations — absolute-return strategies offer the possibility of stepping off the markets roller coaster.

Yet investors would be right to be cautious. During the 2008 financial crisis, some investment strategies failed to live up to their all-weather billing, tracking the market down as it fell. Does the concept still hold water? I believe so, but there are some important factors to consider in evaluating any strategy that purports to be absolute return.

What it is (and isn’t)

First, some definitions. An absolute-return strategy:

• Can be defined as one that seeks to achieve positive returns in all market environments.

• Usually targets a positive return over cash. However, some other target may be selected, either real or nominal.

The range of potential return targets is wide, which means that absolute-return strategies can be used for a variety of objectives. For example, a relatively conservative strategy (e.g. LIBOR plus 100 basis points) might be used to broaden a traditional fixed-income portfolio invested primarily in domestic bonds; a strategy with a higher return target might be used to diversify the equity/return-seeking component of a pension portfolio.

Since there are some common misconceptions, it is worth considering what an absolute-return strategy is not; namely, it:

• Is not necessarily a hedge fund. Although many hedge funds target absolute returns, the approach is employed in a wide variety of investment vehicles and separate accounts.

• Does not guarantee a specific return level. Targeting a positive return over the risk-free rate necessarily involves taking some amount of risk.

On the subject of risk, one way to categorize absolute-return strategies is by their approach to capital preservation. Some will seek to achieve positive returns consistently, always aiming to preserve capital in the short term. Others target a positive return over a longer time horizon and will accept periods of negative returns in the short to medium term.

Role of absolute return

While absolute return may be used to pursue a variety of objectives, there are essentially three reasons to allocate to this type of bond strategy:

• Manage interest rate risk: Absolute-return bond strategies target positive returns even when rates are rising.

• Increase portfolio diversification: Absolute-return strategies ought to have a low correlation to strategies that are managed relative to benchmarks.

• Enhance return: While we believe that interest rates are more likely to rise over the medium term, the global recovery remains weak. This means that bond yields will likely stay low for some time. Absolute-return strategies offer the potential to increase portfolio returns without taking on substantial beta (market) risk.

What to look for

Given these potential uses for absolute return, the investment approach may make sense for many institutional investors. The challenge, as ever, is in selecting the right strategy. There are several factors that can make a difference in whether an absolute-return strategy is likely to achieve its objective consistently.

First, a strategy that has available to it a wide range of alpha sources — government fixed income, investment-grade credit, high yield, emerging market debt, currencies and so on — has a better chance of consistently delivering positive returns. This puts a heavy load on the manager; making calls on all of these alpha sources requires deep resources.

A second important factor is that a fund maintains liquidity — a lesson many investors learned the hard way during the financial crisis. With yields low in the run-up to the crisis, some absolute-return funds were tempted into illiquid sectors and could not trade out of these positions without incurring heavy losses.

Third, the absolute-return manager needs specialist investment skills. Many strategies take both long and short positions, and may also use derivatives. Being a strong long-only manger is not necessarily an indicator of skill at shorting securities.

Fourth, given the range of potential alpha-generating ideas that may be pursued, it is essential that the manager follows a highly disciplined investment process. This ensures that appropriate risk management is in place to help safeguard against negative outcomes; after all, an absolute-return strategy should be unconstrained, not anything goes. On a related note, transparency is also essential: absolute return is a broad church, so it is vital that investors understand exactly how the manager is trying to generate return.

This checklist of key features highlights the importance of exercising care before allocating to an absolute-return strategy. Nevertheless, given the hurdles currently facing bond investors, absolute return could play a useful role in helping investors navigate the challenging times ahead.