Gilts present pathetic value. What are the alternatives?

Today, interest rates on either side of the Atlantic are at all-time lows, while the yield – or the income return of an investment – on government bonds, such as gilts, has tended to follow suit.

Investors currently reap little reward from lending money to governments in the developed world. In Europe in particular, government bond yields have reached record lows, and in some cases moved into negative territory, following the European Central Bank’s move to cut its deposit rate to a level below zero.

Investors are therefore rightly wondering where to find yield within fixed income markets. At the same time, they are mindful of the growing signs of economic strength in the UK and the US, and are concerned about losses to capital when interest rates begin to rise, as bond prices typically move inversely with interest rates.

The good news is that there are answers available.

With yields more likely to rise than fall from here, protecting against capital loss becomes increasingly important. Investment approaches that employ absolute return strategies are, as a result, gaining popularity.

These typically target a return above zero, or above a positive rate such as Libor, regardless of the direction of wider fixed income markets.

An absolute return strategy relies on the investment manager's skill to take views across different bond investments, including the positioning in different types of bonds and the exposure to interest rates and currencies.

Through the use of derivatives the strategy may also be able to profit from falling as well as rising markets.

Derivatives can also be structured to take advantage of the relative price differences between certain assets. For example, two assets may be falling in price but at different speeds; this presents opportunities for a flexible strategy with the right instruments at its disposal.

A well-managed absolute return bond fund run by an experienced, multi-specialist fixed income team might sit well in a pension scheme’s defensive asset allocation, potentially alongside an explicit liability-driven investment strategy.

Here, the fund can seek to generate a return in excess of Libor on the cash held alongside the LDI mandate. An absolute return vehicle could also sit in the return-seeking element of an investment strategy, offering a source of return uncorrelated to other parts of a pension scheme’s portfolio, such as equity or multi-asset approaches.

Taking the benefit from rising rates

While rising interest rates are generally bad for traditional fixed income assets, ‘floating rate’ securities offer more protection. A floating rate security is a bond that pays a coupon with a specific reference to an underlying floating interest rate, such as Libor. As the underlying Libor rate rises, so too do the coupon payments on the bond, and vice versa.

Asset-backed securities are a good example. Investors backed away from these securities in the aftermath of the global financial crisis as the assets became increasingly complex and difficult to understand. This fear has unjustly remained in some cases and, with some banks having to sell their holdings as a result of new legislation, opportunities are presenting themselves.

Secured loans are another asset class offering floating rates. The term ‘secured’ refers to the higher priority given to these loans over the assets of a company in the event of a default. Secured loans are an important source of financing for certain businesses, along with the high-yield market, and a potentially attractive source of return for investors when rates rise.

Yields may be low and rate rises ahead, but there are still opportunities for fixed income investors. Be it by utilising a broad range of techniques as part of an absolute return approach, or actively managing exposure to instruments such as ABSs and secured loans, it remains possible for experienced fixed income teams to generate improved levels of income and protect capital.

Kevin Adams is director of fixed income and a member of the fixed income investment strategy group at Henderson Global Investors