Newton's approach to absolute-return bond investing

Bond markets are driven by investors' expectations about interest rates and inflation. As these expectations change, so do bond yields. Throughout much of the past two decades, low inflation and steady economic growth have allowed bond markets to be relatively stable. However, the global credit crisis changed the background for fixed-income investors radically: short-term interest rates were cut to unprecedented lows and government debt levels rose to historic highs. In the aftermath of the economic downturn, a rise in interest rates (which may be required as part of an effort to combat inflation) could create a 'bear' market in bonds. As most investors hold bonds for their scope to protect capital and income, bear markets in bonds can be especially painful (and usually unexpected). There are two ways in which bond investors may lose capital: through default and via rising interest rates. During the global credit crisis, investors experienced some of the former; as the recovery struggles to take hold, they may be vulnerable to more of the latter.

There are several ways in which investors may limit capital losses in an environment of rising interest rates. For example, if interest-rate expectations are mounting, use of derivatives to offset the risk of higher rates should be beneficial. Such a strategy need not be complicated and need not cover an entire investment portfolio; buying put options on government bonds, for instance, can be an effective way to generate positive returns from falling bond prices. Alternatively, adding holdings of high-yield corporate bonds may allow investors to benefit from an asset class that tends to do well during times of strong economic growth. Whichever approach investors take in seeking to limit capital losses, their priority should be to keep their strategy simple and liquid in order to provide adequate protection of capital in the event that markets become unstable.

Our global investment themes are long-term in nature and the forces to which they refer tend to have a significant effect on interest rates and currencies. Using themes to identify areas of opportunity and risk gives Newton an advantage over other investment managers, who may be caught up in the short-term 'noise' that affects markets. Current themes include global realignment and deleverage, both of which have encouraged our bias to currencies other than the euro, the yen and the US dollar. We favour, for example, the Australian dollar, the Swedish kroner and some Asian currencies, which are not tarnished by excessive debt and which enjoy strong economic support.

In our opinion, an absolute-return approach that relies upon investment manager skill and which harnesses a broad range of opportunities should be clear and comprehensible, and have the potential to achieve attractive long-term returns. Newton Global Dynamic Bond is a dynamic, absolute-return strategy which may invest opportunistically in government bonds, emerging-market sovereign debt, and investment-grade and high-yield corporate instruments. It may also hold currencies and derivatives to generate additional returns and control risk. Given the prevailing (ultra-low) interest-rate backdrop, there is a threat that central banks have been too slow to remove their stimulus, and that inflation expectations will rise. Traditional bond funds would be vulnerable to higher rates and to expectations of higher inflation, but a diversified fixed-income portfolio, with some downside protection, should still be able to make a positive return, even in a rising interest-rate environment.