Pictet-Absolute Return Fixed Income: unlocking the potential of a rapidly-changing bond market Pictet Asset Management May 2014 For professional investors only
Overview From 16 to 9. Over the past decade, the number of sovereign borrowers rated triple-a by Standard and Poor's has almost halved. There is probably no clearer testament to the damage caused by the financial crisis. But it is not the only momentous change facing fixed income investors. In another break with the past, policymakers in the developed world no longer worry about the moral hazard of intervening in the capital markets. Driving down real interest rates close to zero has been the policy of choice in the US, UK and Japan, while in the euro zone it has become de rigueur to encourage banks to buy the bonds of those governments with the weakest credit credentials. If dealing with unorthodox monetary and fiscal policies is not challenging enough for fixed income investors, traditional bond benchmarks and the strategies tied to them do not help matters. In fact, they often amplify risks. Because these indices are capitalisation- or, perhaps more accurately, liability-weighted, they expose investors to the governments and corporations that issue the most debt. This not only leaves participants vulnerable to the potentially unfavourable shifts in borrower creditworthiness, it also restricts their access to more attractive investment opportunities elsewhere. The bond investor s plight is further complicated by a recent deterioration in market liquidity. The introduction of more stringent financial regulations has forced large investment banks to cut back on fixed income trading. With marketmakers in shorter supply, trading conditions in the secondary market are worsening. Volatility has risen as a result. It is due to these shifts that the investment climate in fixed income is becoming the toughest it has been in a generation. This presents a dilemma for investors. While their need for capital protection and reliable streams of income remains undiminished, their reliance on the strategies that have delivered success in the past now threatens to introduce unintended risks into their portfolios. At Pictet Asset Management, we believe one solution to this problem lies in the adoption of a more flexible approach to bond investing. By pursuing a strategy that ignores the constraints of a benchmark, targets absolute rather than relative returns and focuses on protecting capital during difficult market conditions, investors should be better equipped to tackle the difficulties that lie ahead. The Pictet-Absolute Return Fixed Income strategy adopts such an approach. 2 Pictet Asset Management
Our approach to absolute return fixed income investing In pursuing a flexible approach that targets absolute returns, investors may find they need to abandon some conventional ideas about bond investing. At the very least, they should be prepared to: - look further afield: they should seek income and capital return from a broad range of fixed income asset classes whose returns are not highly correlated with one another - look beyond the economic cycle: they should focus on identifying and harnessing structural trends that promise to exert a major influence on investment returns over the long run - diversify risk at every opportunity and methodically seek to maximise risk-adjusted return: investors should make the diversification of sources of risk and return a primary investment objective; they must also take great care to express investment ideas in a way that offers the most efficient trade-off between prospective return and volatility. Pictet-Absolute Return Fixed Income: unlocking the potential of a rapidly-changing bond market 3
1. Look further afield Bond investors have traditionally fallen into two camps. There are those that adopt a passive strategy because they believe markets are efficient, and those who hold the opposite view and task themselves with outperforming a reference index. Yet these approaches are not the polar opposites they appear to be both expose investors to the shortcomings of capitalisation-weighted benchmarks. Much like heavenly objects in the cosmos, cap-weighted bond indices exert a gravitational force. They pull investors active and passive alike towards the securities of the most indebted borrowers and away from fixed income securities whose returns are uncorrelated with developed market government bonds. As a result, there is often surprisingly little to distinguish the composition of long-only, actively managed portfolios from their passive counterparts. Both are exposed to the shifts in the broader market environment. To construct a portfolio capable of delivering attractive returns in all market conditions, we believe investors should ignore the constraints of an arbitrary benchmark and fully embrace bonds in all their forms. The fixed income market is home to a wide range of securities developed and emerging, investment and non-investment grade, government and corporate, inflation-linked and nominal each of which exhibits a distinct risk-return profile. Having the freedom to invest across all of these areas, as well as interest rate, currency and credit derivatives, means investors can seek out uncorrelated assets and mispriced securities wherever they may be. This can help diversify sources of risk and return within a portfolio, giving it the potential to gain in value across all phases of the economic and financial cycle. Fixed income a broad range of investment opportunities FIG 1: CORRELATION OF FIXED INCOME ASSET CLASSES 1 Correlations Emerging Local Asia Local Latam Local Emerging Local Currencies Emerging USD US Government Investment Grade USD Global High Yield USD Emerging Local 1.00 0.82 0.80 0.93 0.76 0.13 0.53 0.61 Asia Local 1.00 0.64 0.73 0.62 0.25 0.54 0.44 Latam Local 1.00 0.78 0.72-0.03 0.41 0.61 Emerging Local Currencies 1.00 0.67 0.00 0.39 0.58 Emerging USD 1.00 0.25 0.72 0.74 US Government 1.00 0.60-0.22 Investment Grade USD Global High Yield USD 1.00 0.49 1.00 Source: Pictet Asset Management 1 Data taken from monthly observations covering period 31.12.2001-31.03.2014. Based on data from following indices: JPMorgan GBI-EM global diversified index, JPMorgan EMBI Global Index, Barclays Capital US High Yield 2% Issuer Capped index, JPMorgan Global GBI Index, Barclays Global Aggregate Bond Index. 4 Pictet Asset Management
2. Look beyond the economic cycle a thematic approach focused on the long term Many bond investors spend a great deal of time and effort attempting to forecast economic conditions one, two or several years into the future. In doing so, conventional wisdom holds, they arm themselves with the information they need to make shrewd investment decisions. Yet this approach has a number of drawbacks. Economic forecasts are rarely accurate. Official economic data are often unreliable and prone to revision, while each business cycle is invariably different from the one that preceded it. There is also the knotty problem of distinguishing cause from effect in any statistical analysis of the economic system. The growing complexity of the investment landscape only adds to these difficulties. Markets are increasingly influenced by a number of secular trends that have evolved independently of the economic cycle. Examples include the widespread use of unconventional monetary policy, and tighter regulation of the world s banks. But there are many more. We believe investors should look beyond the economic cycle and focus instead on identifying the structural changes occurring within the financial system. A number of these secular investment themes underpin the positioning of the Pictet-Absolute Return Fixed Income strategy. By selecting investments that harness these trends, investors can more effectively diversify the sources of risk and return in their portfolios. a. Lower rates for longer we believe the forces that have conspired to push interest rates to historic lows will be features of the investment landscape for years to come. With developed world governments facing an uphill struggle in their bid to reduce debt to stable levels, austerity and financial repression will remain the policy tools of choice. This should continue to put downward pressure on real interest rates. What is more, banks reduced desire and capacity to make corporate loans, weak investment demand among advanced economies and excessive capacity in emerging markets look set to exert a downward force on interest rates across the world. b. Stuttering, protracted reform of the euro zone one legacy of the financial crisis is a long, complicated reform of the euro zone, the world s second-largest bond market. A banking union and a fiscal transfer mechanism under which the public debts of euro zone members are pooled are essential to safeguard the currency bloc s future. Yet given the politicallycharged environment in which decisions are taken, it will take time for the region to overhaul its economic and fiscal structure. We expect progress towards reform to be slow and uneven and such a process is certain to result in as many investment opportunities as it does risks. Pictet-Absolute Return Fixed Income: unlocking the potential of a rapidly-changing bond market 5
c. A newly-assertive Japan the events unfolding in Japan point to a significant change in the country s economic and investment potential. Under the leadership of prime minister Shinzo Abe, and thanks in no small part to the bold moves of its new central bank governor, a country long synonymous with recession, deflation, debt and ineffectual government finally appears to be getting to grips with the problems that have plagued it for much of the past 20 years. d. An economic transformation in China China has begun what promises to be a long and turbulent journey to economic reform. The country is seeking to reduce its dependence on exports and boost domestic consumption in an effort to sustain a healthy level of economic growth into the future. Capital market liberalisation, the expansion of Chinese bond markets and potentially lower economic growth in China hold out the prospect of fundamental change in global fixed income markets. China bond markets witnessing rapid expansion FIG 2: VOLUME OF RENMINBI-DENOMINATED INTERNATIONAL DEBT SECURITIES, USD BILLION 90 80 x7 70 60 50 40 30 20 10 0 2006 2007 2008 2009 2010 2011 2012 2013 Source: Bank for International Settlements 6 Pictet Asset Management
3. Diversify risk at every opportunity and methodically optimise the risk-reward trade-off Diversifying sources of return is key With the fixed income market undergoing major upheaval, the mitigation of risk has taken on greater significance in bond portfolio management. In our view, an effective way to dampen the volatility of returns and keep risks to a minimum is to embrace diversification at every stage of the portfolio construction process. On one level, this involves taking great care to avoid over-exposing a portfolio to any one investment theme, idea or source of return. On another, it means ensuring investment convictions are expressed in a way that offers the most efficient trade-off between risk and return. a. Diversification by investment theme It is important to ensure a portfolio is not hostage to any one investment theme. If one thesis does not play out as envisaged, the strategy s managers must be confident that the portfolio is sufficiently diversified that weak returns in one area do not eclipse strong returns in another. With this in mind, we make sure that the themes we invest in are evenly represented in the portfolio. In other words, no one idea should be more prominent than another. We believe this approach is distinct from those pursued by strategic bond funds or active benchmarkoriented strategies. The former typically concentrate investments in high-conviction ideas, while the latter tend not to venture far beyond the boundaries of their reference index. b. 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. The Pictet- Absolute Return Fixed Income strategy aims to secure returns from three main sources: interest-ratesensitive securities, such as interest rate swaps and developed government bonds; spread products, such as investment-grade corporate debt and currencies. Being able to express investment ideas along more than one dimension is an obvious benefit. But it is important to recognise that each source of return is also a potential source of risk. This is why our investment managers ensure the portfolio s risk budget is equally distributed across currency (emerging and developed), interest rate (government bond markets) and credit securities (investment and speculative-grade). FIG 3: BREAKDOWN OF PICTET-ABSOLUTE RETURN FIXED INCOME STRATEGY BY CURRENCY, CREDIT AND INTEREST RATE Ex-ante Volatility (in %) 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 Currency Interest rates Credit (spread) 0.0 09.2012 11.2012 01.2013 03.2013 05.2013 07.2013 09.2013 11.2013 01.2014 Source: Pictet Asset Management Pictet-Absolute Return Fixed Income: unlocking the potential of a rapidly-changing bond market 7
c. Efficient implementation of investment themes With the discretion to invest across a broad range of fixed income asset classes, our investment managers are able to express their ideas in a way that can offer an efficient trade-off between risk and return. For instance, we have a number of options with which to express our conviction that interest rates will remain low for a protracted period. These range from a long position in US Treasuries to an overweight stance in European high-yield bonds. A distinctive aspect of our investment approach is our ability to identify a security, or combination of securities, that expresses this idea in a way that holds out the prospect of attractive returns but simultaneously limits the scope for capital loss should the thesis not play out. This process is illustrated in Figures 4 and 5. It shows that investing exclusively in US Treasuries would, if our thesis were to play out as expected over a one-year horizon, deliver a positive return of 3.7 per cent. In the worst-case scenario, however, the loss is forecast to be 2.8 per cent. The pay-out ratio of the strategy dividing prospective return by prospective loss is 1.31: 1. Using the same approach, we find that the pay-out ratio of a long position in European high-yield European bonds (excluding financials) is 1.34:1. Neither of these pay-out ratios is particularly compelling. But combining a long position in US Treasuries which typically exhibit lower volatility with a long position in European highyield bonds narrows the range of outcomes, producing a more favourable pay-out ratio of 2:1. A key aspect of our approach is its focus on value we screen securities based on their valuations, using only the most attractively priced to express our investment ideas. Efficient implementation of investment themes lower rates for longer FIG 4: LONG POSITION IN EUR HIGH-YIELD BONDS OFFERS UNATTRACTIVE PAY-OUT RATIO Return, BoA Merrill Lynch EUR high-yield bond index (ex-financials) 250 200 150 100 50 0 2001 2002 EUR high-yield bonds (ex-financials) can be expected to deliver strong returns should interest rates remain low 2003 2004 2005 2006 2007 2008 2009 While the strategy would deliver an attractive return in the best-case scenario, the potential loss is too great; an alternative strategy is required to reduce the downside risk 2010 2011 2012 2013 1-year expected return in most favourable scenario: +14% 1-year expected loss in most unfavourable scenario: -11% FIG 5: PAY-OUT RATIO SIGNIFICANTLY IMPROVED BY COMBINING EUR HY WITH US TREASURIES Return Feb 2001 = 100 250 Combined strategy BoA Merrill Lynch EUR high-yield bond index (ex-financials) 200 US Treasuries 150 100 By combining a long position in EUR high-yield bonds with US Treasuries, a more favourable risk-reward trade-off is achieved 1-year expected return in most favourable scenario: +4% 1-year expected loss in most unfavourable scenario: -2% 50 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Pictet Asset Management 8 Pictet Asset Management
The role of Pictet-Absolute Return Fixed Income in a diversified portfolio Pictet-Absolute Return Fixed Income offers investors the potential to secure attractive-risk adjusted returns over the course of the market cycle. Because our investment managers seek to capitalise on secular rather than cyclical trends, and because they also have the freedom to invest in a broad range of bonds, they have greater scope to mitigate volatility and identify mispriced securities than strategies tethered to capitalisationweighted indices. But the strategy s emphasis on risk management and diversification should not be underestimated. It is instrumental in ensuring the portfolio delivers an efficient trade-off between prospective volatility and return. Thanks to its distinct characteristics, the returns generated by Pictet- Absolute Return Fixed Income also exhibit a low correlation with those of most equity and fixed income classes. This means an allocation to the strategy could improve the risk-return profile of a balanced portfolio. Pictet-Absolute Return Fixed Income a good diversifier FIG 6: CORRELATION OF RETURNS PICTET-ABSOLUTE RETURN VS MAJOR ASSET CLASSES 2 Absolute Return Fixed Income Global bonds Global bonds (hedged) US bonds EM bonds, USD EM local currency bonds US credit World stocks US stocks Commodities High-yield bonds European credit Absolute Return Fixed Income 1.00 Global bonds 0.00 1.00 Global bonds (hedged) 0.35 0.69 1.00 US bonds 0.25 0.66 0.90 1.00 EM bonds, USD 0.48 0.54 0.58 0.49 1.00 EM local currency bonds 0.46 0.33 0.50 0.39 0.93 1.00 US credit 0.32 0.64 0.90 0.98 0.55 0.45 1.00 World stocks 0.25 0.17-0.06-0.09 0.42 0.33-0.07 1.00 US stocks 0.16-0.01-0.12-0.17 0.23 0.23-0.17 0.89 1.00 Commodities 0.09 0.10-0.05-0.08 0.13 0.07-0.08 0.39 0.35 1.00 High-yield bonds 0.44 0.50 0.29 0.22 0.83 0.68 0.28 0.63 0.37 0.24 1.00 European credit 0.40 0.53 0.81 0.57 0.50 0.45 0.60-0.05-0.11-0.06 0.29 1.00 Source: Pictet Asset Management 2 Returns for Pictet-Absolute Return Fixed Income representative portfolio; bond market returns taken from Barclays Capital fixed income indices; equity returns taken from MSCI World Index and S&P 500 Index; commodities returns taken from SP GSCI Index; data covers period 04.09.2012-31.03.2014 Pictet-Absolute Return Fixed Income: unlocking the potential of a rapidly-changing bond market 9
Concluding remarks have historically provided investors with reliable streams of income and steady capital returns. Yet the profound changes under way in the fixed income market indicate bond returns will be more volatile than they have been over the past two decades. Investors looking to bonds to provide an anchor for their diversified portfolios should consequently modify their approach. We believe that flexible bond strategies such as Pictet-Absolute Return Fixed Income that ignore the constraints of a benchmark, target absolute rather than relative returns and make capital preservation an explicit investment objective are more likely to prosper than traditional benchmarked strategies in this new environment. ABOUT PICTET-ABSOLUTE RETURN FIXED INCOME The fund offers a flexible and unconstrained approach to bond investing; we aim to construct a diversified portfolio using the broadest possible investment universe. Its flexible approach is designed to preserve capital during periods of market volatility. It has a target return of 3-4 per cent over cash* per annum gross of fees. * Over USD Libor or equivalent in share class currency 10 Pictet Asset Management
Contacts For further information, please visit our websites: www.pictet.com www.pictetfunds.com This material is for distribution to professional investors only. However, it is not intended for distribution to any person or entity who is a citizen or resident of any locality, state, country or other jurisdiction where such distribution, publication, or use would be contrary to law or regulation. Information used in the preparation of this document is based upon sources believed to be reliable, but no representation or warranty is given as to the accuracy or completeness of those sources. Any opinion, estimate or forecast may be changed at any time without prior warning. Investors should read the prospectus or offering memorandum before investing in any Pictet-managed funds. Tax treatment depends on the individual circumstances of each investor and may be subject to change in the future. Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. This document has been issued in Switzerland by Pictet Asset Management SA and in the rest of the world by Pictet Asset Management Limited, which is authorised and regulated by the Financial Conduct Authority, and may not be reproduced or distributed, either in part or in full, without their prior authorisation. For UK investors, the Pictet and Pictet Total Return umbrellas are domiciled in Luxembourg and are recognised collective investment schemes under section 264 of the Financial Services and Markets Act 2000. Swiss Pictet funds are only registered for distribution in Switzerland under the Swiss Fund Act; they are categorised in the United Kingdom as unregulated collective investment schemes. The Pictet Group manages hedge funds, funds of hedge funds and funds of private equity funds which are not registered for public distribution within the European Union and are categorised in the United Kingdom as unregulated collective investment schemes. For Australian investors, Pictet Asset Management Limited (ARBN 121 228 957) is exempt from the requirement to hold an Australian financial services licence, under the Corporations Act 2001. For US investors, Shares sold in the United States or to US Persons will only be sold in private placements to accredited investors pursuant to exemptions from SEC registration under the Section 4(2) and Regulation D private placement exemptions under the 1933 Act and qualified clients as defined under the 1940 Act. The Shares of the Pictet funds have not been registered under the 1933 Act and may not, except in transactions which do not violate United States securities laws, be directly or indirectly offered or sold in the United States or to any US Person. The Management Fund Companies of the Pictet Group will not be registered under the 1940 Act. Copyright 2014 Pictet - Issued in May 2014 Pictet-Absolute Return Fixed Income: unlocking the potential of a rapidly-changing bond market 11
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