FOR WHOLESALE CLIENTS ONLY. NOT TO BE DISTRIBUTED TO RETAIL CLIENTS. NOT TO BE REPRODUCED WITHOUT PRIOR WRITTEN APPROVAL. PLEASE REFER TO ALL RISK DISCLOSURES AT THE BACK OF THIS DOCUMENT. September 2017 MANAGING INTEREST RATE RISK WITH AN ABSOLUTE RETURN APPROACH AN OBJECTIVE ASSESSMENT As key global central banks tentatively turn toward monetary policy normalisation, the prospect of a prolonged period of rising interest rates has left some investors questioning the merits of retaining an exposure to fixed income. Investors concerned about the potential for rising interest rates could consider an absolute return approach to bond investing as an alternative or complement to traditional, long-only bond strategies. Insight s Global Absolute Return Bond Fund combines both a capital preservation objective in the shorter term with a meaningful return objective over the medium term, irrespective of the interest rate environment. Launched in December 2015, the Fund is based on Insight s global absolute return fixed income strategy, which has an extensive 10-year track record. This strategy retains both the diversification benefits and investment opportunities from investing across the global bond universe, with the ability to express positive or negative views on the direction of markets. GLOBAL INTEREST RATES: TO RISE OR NOT TO RISE? THAT IS THE QUESTION After almost a decade of ultra-accommodative monetary policy, key developed market central banks are now shifting their focus toward policy normalisation. The Federal Reserve (Fed) kickstarted the process in January 2014 by tapering its bond purchase programme, a process it concluded by October that same year. It proceeded to the next phase of normalisation a year later by implementing a 25 basis points (bp) rate hike, the first since 2006, and has implemented a further three hikes since then. An announcement on its strategy for balance sheet reduction looks likely in late 2017. While the European Central Bank (ECB) is at a different stage of the policy normalisation process, it looks set to provide some clear guidance on tapering of its bond purchase programme in the near term and may begin raising interest rates in 2018. Although Australia s economic narrative has largely diverged from that of the US and Europe over the past decade, the Reserve Bank of Australia (RBA) currently maintains its benchmark cash rate at the historically low level of 1.5%. The RBA may be inclined to sync its monetary policy cycle with that of the Fed and ECB should inflation return to target and growth accelerate. For some investors these cues mark the start of a prolonged period of tighter monetary policy and rising interest rates, and increase concerns over the outlook for bonds (Figure 1). Such concerns are understandable because bond prices move inversely to movements in interest rates. Most at risk are government treasury bonds, which are purer interest rate securities and lack the additional spread component of credit bonds. Also at greater risk are longer-duration bonds, which have inherently higher levels of interest rate sensitivity (or duration), and low-yielding bonds which lack the carry cushion to absorb adverse price movements. During the most recent period of monetary easing prompted by the 2008-2009 global financial crisis, interest rate sensitivity was viewed less as a concern and more as a boon for investors. The sharp decline in global interest rates led bonds to outperform. The reverse may be the case if we enter a prolonged period of rising rates one would expect bonds to incur capital losses as prices fall. With many core government bond yields currently at multi-decade lows, the cushion available to absorb any meaningful move higher in interest rates is severely limited. Hence the concerns shared by many bond investors. Figure 1 Have we reached an inflection point for interest rates? 9 8 7 6 % 5 4 3 2 1 0 Aug 97 Jul 99 Jul 01 Jul 03 Jul 05 Jul 07 Jul 09 Jul 11 Jul 13 Jul 15 Jul 17 Federal funds target rate - upper bound ECB policy rate RBA cash rate For illustrative purposes only.
THE LIMITATIONS OF LONG-ONLY, CONSTRAINED FIXED INCOME INVESTING By design, traditional long-only or constrained approaches to fixed income investing limit the opportunity set to that prescribed by a benchmark. In the case of government bond funds where duration is a key driver of return investors are typically exposed to adverse interest rate moves, with limited scope to mitigate these risks. These funds are structurally long duration by design and the prospect of rising interest rates over the coming years may leave these investors exposed to capital losses. Even in the case of funds managed against more broad-based fixed income benchmarks such as the Bloomberg Barclays Global Aggregate Index 1 tracking error constraints can restrict the degree to which fund managers can avoid the most interest rate-sensitive segments of the market, irrespective of their overall view on the direction of bond yields. NOT ALL FIXED INCOME IS EQUAL The global fixed income market is very diverse in terms of instrument type, sector, credit quality, maturity and geographical composition. According to the Bank for International Settlements latest estimates, there is currently in excess of US$100 trillion worth of fixed income securities outstanding globally 2. Fixed income provides scope for opportunity far beyond the traditional core sectors of developed market government bonds and investment grade credit. Opportunities exist across the risk/return spectrum and include investment grade and high yield credit, global treasuries, securitised products and emerging market sovereign and corporate debt. Duration, yield curve, credit, geography and sector selection, inflation and currency all provide avenues for alpha generation. We believe the diversification benefits and scope for generating positive returns using fixed income should not be ignored. INVESTORS SHOULD CONSIDER AN ABSOLUTE RETURN APPROACH TO FIXED INCOME With such a broad palette of opportunity available, fixed income ought to be an integral part of any investor s portfolio. Investing in bonds does not mean, however, that investors should be forced to assume unnecessary interest rate risk particularly if they are concerned about the potential for rising rates. An absolute return approach to fixed income is naturally unconstrained and allows investors to benefit from the sheer breadth of alpha and diversification opportunities that the market provides, without the risk and sector biases inherent in more traditional, long-only constrained approaches. Such strategies typically seek a lower volatility profile and have the potential to deliver positive returns in both strong and weak market environments. In addition to sourcing alpha opportunities from across the fixed income universe, absolute return fixed income strategies can use techniques to generate positive returns in declining markets, preserve capital and smooth volatility. As a result, they tend to have a low correlation to both equity and bond markets and act as effective portfolio diversifiers. INSIGHT S GLOBAL ABSOLUTE RETURN BOND FUND Insight has a proven track record of managing absolute return fixed income portfolios tested through a full market cycle, with the first mandate for our global absolute return fixed income strategy launched in August 2006. In December 2015 we launched the Insight Global Absolute Return Bond (GARB) Fund. GARB aims to provide a positive absolute return in all market conditions over a rolling 12-month period; and a 3% annualised return in excess of the Bloomberg AusBond Bank Bill Index over rolling three-year periods 3. The strategy is co-managed by Andrew Wickham and Peter Bentley, Insight s Heads of Global Rates and Global Credit respectively, who are supported by a team of more than 100 global fixed income specialists. The strategy maintains no structural bias to positions or sectors and seeks high levels of diversification (Figure 2). Figure 2 Diversification with a global opportunity set Government bonds Investment grade credit Inflation linked bonds Global absolute return fixed income strategy Asset-backed securities Emerging market debt High yield and loans Currency Figure 2: For illustrative purposes only. 1 The Bloomberg Barclays Global Aggregate Index is a measure of global investment grade debt from 24 local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitised fixed-rate bonds from both developed and emerging markets issuers. 2 Bank for International Settlements (BIS), June 2017, BIS Quarterly Review June 2017 - International Banking and Financial Market Developments. 3 This is not a guarantee, may not be achieved and a capital loss may occur. Funds which have a higher performance aim generally take more risk to achieve this and so have a greater potential for the returns to be significantly different than expected.
A FLEXIBLE, UNCONSTRAINED AND ABSOLUTE RETURN APPROACH Insight s global absolute return fixed income strategy is fully flexible and invests across the global fixed income universe. The portfolio managers dynamically allocate across sectors, maturities, regions and credit quality buckets seeking out the best risk-adjusted alpha opportunities. To demonstrate the strategy s diversification attributes, Figure 3 illustrates rolling 12-month correlations against representative global equities and global bond indices 4. This chart demonstrates the diversification benefits that can be achieved by adding the strategy as a complement to a traditional portfolio consisting of long-only bond and equity exposures. Throughout the market cycle, the strategy s correlation to both equities and bonds has shifted considerably, often exhibiting low or negative correlations implying a returns profile that has a minimal or inverse relationship to the returns profile of global equities and global government bonds. This chart also demonstrates the strategy s dynamism the portfolio managers dynamically alter risk and sectoral exposures in response to the constantly changing market environment and identification of alpha opportunities. Diversification is embedded within Insight s risk framework. Insight applies an in-house, bespoke and proprietary units of risk approach to all of its fixed income portfolios including those in our global absolute return fixed income strategy. After the portfolio managers formulate their investment decisions, this framework allows positions to be scaled appropriately and consistently ensures diversification of all the risks that the strategy actively takes. Figure 3 Rolling 12-month correlations between the Insight global absolute return fixed income strategy and global markets 0.8 0.6 % 0.4 0.2 0.0-0.2-0.4-0.6 Aug 07 Jul 09 Jul 11 Insight global absolute return fixed income strategy/global equities Insight global absolute return fixed income strategy/global aggregate bonds Insight global absolute return fixed income strategy/global government Jul 13 Jul 15 Jul 17 A FIXED INCOME STRATEGY FOR ALL MARKET ENVIRONMENTS The strategy s dynamic correlation profile also reflects its ability to take both long and short positions. It does this through the use of derivatives; to manage the strategy s credit, duration, currency and inflation exposures. With respect to duration specifically, the strategy maintains a neutral exposure of zero years centred around a plus/minus 5-year range (Figure 4). As such, if the portfolio managers have no view on duration they can hedge duration exposure fully and maintain no sensitivity to interest rate movements, leaving returns to be generated from other alpha sources such as credit selection, currency or yield curve trades. In the event the portfolio managers wish to express a negative view on duration because they are concerned about rising interest rates they can use interest rate derivatives to take headline duration net short, positioning to benefit from rising interest rates. This stands in marked contrast to long-only, constrained fixed income strategies that must accept long duration exposures irrespective of the underlying view on interest rates. Figure 3: Source: Insight Investment, Bloomberg, as at 31 July 2017. 4 Given GARB s December 2015 inception, throughout this piece we use the Insight bonds plus 200 strategy, inception August 2006, as representative of our global absolute return fixed income strategy. Insight s bonds plus 200 strategy has an investment objective to deliver positive absolute returns on an annual basis, with a performance target of cash plus 2% pa (gross of fees) over rolling three-year periods. Global equities represented by the MSCI World Equity Index (hedged AUD); global government bonds represented by the Bank of America Merrill Lynch Global Government Bond Index (hedged AUD); global aggregate bonds represented by the Bloomberg Barclays Global Aggregate Bond Index (hedged AUD). This is not a guarantee, may not be achieved and a capital loss may occur. Funds which have a higher performance aim generally take more risk to achieve this and so have a greater potential for the returns to be significantly different than expected.
Figure 4 Insight global absolute return fixed income strategy: headline duration history 5 4 Max duration +5 years Years 2 0-2 -4 Max duration -5 years Mar 08 Jun 09 Jun 11 Jun 13 Jun 15 Jun 17 Figure 5 demonstrates the practical success of Insight s global absolute return fixed income strategy. Using A$100,000 as a base the chart compares the returns and volatility profile of the strategy since inception with representative indices for global equities, global government bonds and an equally-weighted blend of the strategy and global equities6 Global equities represented by the MSCI Equity World Index (hedged back to AUD using interest rate differentials); global government bonds represented by the Bank of America Merrill Lynch Global Government Bond Index (hedged back to AUD using interest rate differentials). Past performance is not a guide to future performance. Information provided for illustrative purposes only and should not be construed as investment recommendations.. We have chosen global equities and global government bonds because these asset classes demonstrate the dichotomies of equity and debt markets in their purest form, representing the two biggest drivers of risk and return in portfolios. While the strategy underperforms global equities on an overall returns basis A$241,770 (8.42% annualised return) versus A$260,059 (9.15% annualised return) adjusting for risk, it outperforms considerably, generating this return with an annualised volatility of 4.32% versus 15.88% for global equities. The chart also clearly illustrates the markedly different volatility profiles with the strategy taking a considerably smoother path to arrive at its destination. Against a long-only global government bond index, the narrative is similarly compelling: the strategy outperforms from both a returns perspective, resulting in A$241,770 versus A$198,834 (6.50% annualised return), and a volatility perspective (4.32% annualised versus 6.59% annualised). Adding Insight s global absolute return fixed income strategy as a 50% complement to a global equities portfolio, leads to a marginally lower overall return (A$258,792 for the blend versus A$260,059 for global equities only), with dramatically lower volatility than an investment solely in global equities (8.87% for the blend versus 15.88% for global equities). These improved risk/return metrics demonstrate the diversification potential from adding Insight s global absolute return fixed income strategy to a traditional equity-only portfolio. Figure 5 Performance of A$ 100k invested 31 August 2006 31 July 2017 6 300000 250 A$ (thousands) 200 150 100 50 Aug 06 Jul 07 Jul 08 Jul 09 Jul 10 Jul 11 Jul 12 Jul 13 Jul 14 Jul 15 Jul 16 Jul 17 Insight global absolute return fixed income strategy Global equities Figure 4: Source: Insight Investment, as at 31 July 2017. 5 Using Insight bond plus 200 strategy headline duration history. Past performance is not a guide to future performance. Information provided for illustrative purposes only and should not be construed as investment recommendations. Figure 5: Source: Insight Investment, Bloomberg, as at 31July 2017. 6 Global equities represented by the MSCI Equity World Index (hedged back to AUD using interest rate differentials); global government bonds represented by the Bank of America Merrill Lynch Global Government Bond Index (hedged back to AUD using interest rate differentials). Past performance is not a guide to future performance. Information provided for illustrative purposes only and should not be construed as investment recommendations.
Portfolio 6 Value of A$100k invested 31 August 2006-31 July 2017 Annualised volatility Global equities A$260,059 15.88% Insight global absolute return fixed income strategy/global equities A$258,792 8.87% Insight global absolute return fixed income strategy A$241,770 4.32% Global government bonds A$198,834 6.59% CONCLUSION As central banks sharpen their focus on monetary policy normalisation, investors are understandably concerned about the prospect of a prolonged period of rising interest rates and what this means for their bond investments. It is evident from the last few years that constrained, fixed income offerings have benefitted from falling interest rates and compressing spreads. Should these tailwinds begin to subside, it is not unreasonable for investors to ask how returns and capital preservation will be delivered in the future under the possibility of different economic and financial market conditions. Indeed, it is worth reflecting upon how your fixed income manager has added value to your portfolio over recent years and whether the same value can be achieved going forward. provides, without being forced to take unnecessary interest rate risk. The broad mandate of Insight s Global Absolute Return Bond Fund aims to deliver on its investment objective in all market environments as it can take advantage of both positive and negative views, with access to the full spectrum of fixed income opportunities. The Fund operates within a rigorous risk framework, re-calibrating the sources of risk within the portfolio on a regular basis. This has enabled the investment team to apply a disciplined approach to investing across the fixed income universe without over-diversification or the introduction of structural biases towards specific sectors such as credit or rates. An unconstrained, absolute return approach to fixed income investing allows investors the potential to reap the diversification and alpha opportunities that the global fixed income universe Source: Insight Investment, Bloomberg August 2017. 6 Global equities represented by the MSCI Equity World Index (hedged back to AUD using interest rate differentials); global government bonds represented by the Bank of America Merrill Lynch Global Government Bond Index (hedged back to AUD using interest rate differentials). Past performance is not a guide to future performance. Information provided for illustrative purposes only and should not be construed as investment recommendations.
FIND OUT MORE Insight Investment Level 2, 1-7 Bligh Street, Sydney NSW 2000 +61 2 9260 6655 Bruce Murphy Director, Australia and New Zealand bruce.murphy@insightinvestment.com Rob Thompson Head of Adviser Distribution rob.thompson@insightinvestment.com www.insightinvestment.com This document is a financial promotion and is not investment advice. This document must not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or otherwise not permitted. This document should not be duplicated, amended or forwarded to a third party without consent from Insight Investment. Insight does not provide tax or legal advice to its clients and all investors are strongly urged to seek professional advice regarding any potential strategy or investment. For a full list of applicable risks, and before investing, investors should refer to the Prospectus or other offering documents. Please go to www.insightinvestment.com. Unless otherwise stated, the source of information and any views and opinions are those of Insight Investment. Telephone calls may be recorded. For clients and prospects of Insight Investment Management (Global) Limited: Issued by Insight Investment Management (Global) Limited. Registered in England and Wales. Registered office 160 Queen Victoria Street, London EC4V 4LA; registered number 00827982. For clients and prospects of Insight Investment Funds Management Limited: Issued by Insight Investment Funds Management Limited. Registered in England and Wales. Registered office 160 Queen Victoria Street, London EC4V 4LA; registered number 01835691. For clients and prospects of Insight Investment International Limited: Issued by Insight Investment International Limited. Registered in England and Wales. Registered office 160 Queen Victoria Street, London EC4V 4LA; registered number 03169281. Insight Investment Management (Global) Limited, Insight Investment Funds Management Limited and Insight Investment International Limited are authorised and regulated by the Financial Conduct Authority in the UK. Insight Investment Management (Global) Limited and Insight Investment International Limited are authorised to operate across Europe in accordance with the provisions of the European passport under Directive 2004/39 on markets in financial instruments. For clients and prospects based in Singapore: This material is for Institutional Investors only. This documentation has not been registered as a prospectus with the Monetary Authority of Singapore. Accordingly, it and any other document or material in connection with the offer or sale, or invitation for subscription or purchase, of Shares may not be circulated or distributed, nor may Shares be offered or sold, or be made the subject of an invitation for subscription or purchase, whether directly or indirectly, to persons in Singapore other than (i) to an institutional investor pursuant to Section 304 of the Securities and Futures Act, Chapter 289 of Singapore (the SFA ) or (ii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. For clients and prospects based in Australia and New Zealand: This material is for wholesale investors only (as defined under the Corporations Act in Australia or under the Financial Markets Conduct Act in New Zealand) and is not intended for distribution to, nor should it be relied upon by, retail investors. Both Insight Investment Management (Global) Limited and Insight Investment International Limited are exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 in respect of the financial services; and both are authorised and regulated by the Financial Conduct Authority (FCA) under UK laws, which differ from Australian laws. If this document is used or distributed in Australia, it is issued by Insight Investment Australia Pty Ltd (ABN 69 076 812 381, AFS license number 230541) located at Level 2, 1-7 Bligh Street, Sydney, NSW 2000. 2018 Insight Investment. All rights reserved. 13604-12-17 (IC0201)