Alternatives get a C grade in first test

The tumultuous interest rate movements last month were the first real test for alternative bond funds, and the results were so-so.

Alternative bond funds, which typically are touted as unconstrained or strategic-income funds, have been marketed to financial advisers as a way to avoid the drama of rising interest rates without ditching bonds altogether.

Most alternative bond funds, however, were unable to live up to that promise last month.

The funds generally have the ability to short and the freedom to invest across a variety of markets in order to lessen the blow of rising rates, but those tools came up short as the 10-year Treasury’s yield shot up 46 basis points last month.

On average, the funds finished the month with a 0.46% loss, better than the average intermediate-term-bond fund’s 1.6% loss but still a loss of principal.

LARGEST FUND HIT HARD

The largest alternative bond fund, the $26 billion Pimco Unconstrained Bond Fund (PUBAX), lost 0.54%, worse than the category’s average.

“May was a really good test,” said Nadia Papagiannis, a mutual fund analyst at Morningstar Inc.

“Overall, I’d give them a C,” she said. “They didn’t lose as much as long-only bonds but could have been a little more hedged.”

The reason for the one-month performance woes essentially boils down to the managers’ not being hedged against rising rates, Ms. Papagiannis said.

“The funds are basically long credit with the option to hedge,” she said. “Most of the time, they’re not hedged.”

So essentially, what advisers in these funds are betting on is that the managers will be able to time the market when it comes to hedging.

“That’s hard to do,” Ms. Papagiannis said.

Despite not being as good as advertised, the funds don’t seem to be losing any steam.

The first week in June, when investors pulled out $9.1 billion from bond mutual funds and exchange-traded funds, the second-biggest weekly outflows since Lipper Inc. started collecting data in 1992, flows into alternative bond funds were basically flat.

And some alternative bond funds deserve an A grade.

The $528 million Driehaus Select Credit Fund (DRSLX) gained 1.2%, and the $370 million Scout Unconstrained Bond Fund (SUBFX) gained 1% last month.

Both funds are ranked in the top 10th percentile of alternative bond funds for the year, according to Morningstar.