Kames Absolute Return Bond fund

With ongoing concerns about The Great Rotation from bonds into equities, fixed income funds that can prosper against tougher conditions are at a premium.

“The main difference, as an absolute return portfolio, is we have greater flexibility to exploit areas of the market we dislike, whereas a long-only fund can only zero weight these.”

Colin Finlayson

One such offering is Kames Absolute Return Bond fund, although co-manager Colin Finlayson stresses the product is designed as a superior alternative to cash and a complement – rather than alternative – to other fixed interest holdings. “We see the fund as a low-risk offering and that is clear from the fairly modest performance target of three-month sterling Libor plus 2-3% net of fees,” he says. “Recent events with Cypriot bank accounts and low rates across much of Europe show holding cash is effectively worthless and with negative yields on many short-dated government bonds, we see this kind of fund offering an alternative for the low-risk end of portfolios.”Kames launched the fund for Finlayson and co-manager Stephen Snowden in September 2011 and the former says the process is broadly similar to the rest of the group’s bond range. “The main difference, as an absolute return portfolio, is we have greater flexibility to exploit areas of the market we dislike, whereas a long-only fund can only zero weight these,” adds Finlayson. “Our product is also largely about finding alpha in bond markets – accounting for 95% of returns, whereas a typical long-only offering gets around 75% from beta. As a fixed income team, we have always been high conviction and focused on alpha so the Absolute Return launch was a natural progression.”Risk neutral While the portfolio includes various pair trades, Finlayson says it is impossible to call a bond fund entirely market neutral, with risk neutral a more accurate description. “If we pair up two assets and run a long gilt/ short Treasury position for example, it will always be the case that such a trade works better in certain environments so it can never be market neutral,” he adds.Finlayson and Snowden run three basic modules on the fund, with a core ‘carry’ portfolio plus rates and credit elements. All three are expected to perform differently at certain stages of a cycle and the managers see this three-way split as providing the flexibility to perform against any backdrop rather than relying on the fortunes of one part of the asset class.Looking at the carry module first, this part of the fund has been a fairly steady 40% of assets since launch and is made up of highquality short duration corporate bonds. “We see this as the buy and hold portion of the fund, seeking quality bonds with a modest income that gets us towards the Libor target,” says Finlayson.“Criteria for inclusion are to be investment grade, BBB-rated or above, and having less than two years to maturity. As we have been running the portfolio for coming up to two years, most of the activity in this area has been reinvesting proceeds as bonds mature but this module is not that actively traded otherwise.” Holdings in this area are names represented across Kames’ bond portfolios, including First Group, ING, Morgan Stanley, Vodafone and GE. Overall, the pair expects the three modules to account for a broadly even share of assets and returns although allocations will shift – carry is currently higher for example and Finlayson says it could creep up as inflows continue, with little point holding cash.Elsewhere, the credit and rates portions are where the managers express more tactical calls and also where the risk neutral concept comes into play. On the former for example, if Finlayson and Snowden like an individual bond, they can hold it and remove interest rate and credit risk using derivatives. They also have more relative value positions – pair trades using credit default swaps to go long one bond and short another – across individual credits and at index level, playing financials against non-financials or dollar versus euro high yield.At launch in 2011, Finlayson says market conditions were not conducive to taking credit risk so the portfolio was skewed towards the rates side, but the former allocation has increased as conditions improved. At present, the credit position is 48% gross and 24% net. Coming finally to the rates module, this includes all the government bond related calls, with cross market relative value and yield curve positions.“Highlighting the low-risk nature of the portfolio, this module is duration neutral and we look to cut out sovereign credit risk as far as possible, avoiding areas like peripheral Europe and focusing on a smaller number of strong markets,” adds Finlayson. “Across the fund, we prefer calls not predicated on a market moving up or down but rather on the relative performance of two assets. If we felt gilt yields were set to rise 50 basis points for example, rather than just selling futures, we would look at which parts of the market would sell off more and take long and short positions accordingly.”Examining some of the credit positions in more detail, Finlayson highlights a long non-financial/short financial trade initiated last October, which took time to pay off but has benefitted more recent performance. “After [ECB president] Mario Draghi made his ‘anything it takes’ speech last year, we felt the risk rally that sparked ran a long way very fast, with good news quickly reflected in bank prices,” he adds.“When we made the trade, the thinking was that Spain would get downgraded shortly after but it actually kept its status on a wave of OMT optimism so the position worked against us for the rest of 2012. We checked to ensure we were still comfortable with it and remained confident financials would struggle again on any setback, with Italian elections and event in Cyprus providing exactly that.”Other successful trades have included a long Atlantia/short Generali and long Santander/ short Intesa SanPaolo. “We are seeking two stocks with some kind of correlation rather than just taking a view on country risk,” adds Finlayson. “With the Atlantia and Generali position for example, both Italian stocks, we again felt the latter had rallied too far and preferred to own an infrastructure name rather than an insurer.”In the rates portfolio, trades have included a long 10-year German bunds/short equivalent French debt, once again based on a pricing case. “France was a popular short in 2011 but did well last year and we felt it had rallied too far,” adds Finlayson. “When the spread differential reached around 60 basis points, we believed the market was being too generous to France given the risks that remain.”No rate rise anytime soon On the general outlook for fixed income, Kames has long believed government bonds are too expensive and will therefore remain at the lower end of the return range for the next few years. That said, Finlayson is not expecting a huge rise in yields while governments around the world continue their zero interest rate policies.“In the US, we may see Treasury yields rise from 1.75% to 2.25% by the year end but while the short end of the curve remains anchored by low interest rates, there is limited scope for a sell-off further down the curve,” he says. “That could change if governments start talking seriously about rate hikes but we see little chance of any such change in policy for at least 18 months.”For Finlayson, this argument means it is hard to accept talk about a great rotation out of bonds, particularly with various macro tail risks remaining around the world. “If you look at flows, investors are buying equities and may have stopped buying bonds for now but that is very different from selling fixed income,” he adds.“Where money is going into equities, it is largely coming out of cash and we see the current environment as one where stocks and bonds can both perform well – we call it a QE trade where everything rallies together.” While still positive on investment grade and high yield, the pair agrees with consensus that returns will be much lower than last year. “Yields are at record lows but spreads still look good relative to government debt,” adds Finlayson.“Investors expecting the same kind of double- digit returns as last year will be disappointed and the case for high-yield is now much more about the yield, with limited capital gains available.” Unlike many peers, Finlayson is less convinced of the case for sovereign emerging market debt and the portfolio is currently net short the asset class.“We have used that position to offset our high-yield exposure, as we have preferred to take our risk in that part of the market,” he adds. “I buy into the emerging market story less than many investors: these markets are clearly in much better shape than 15 years ago but a lot of that improvement is already priced in and heavy inflows to EMD have only skewed prices further. We are also nervous about certain things in the region, with issues in Argentina for example and concerns about capital controls and property rights.” Although broadly cautious on EM sovereigns, Finlayson has held some individual credits in the region but analyses these as bonds against similar assets around the world rather than focusing on their home market.