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Time is ripe for unconstrained bond funds

Advisers warned to do their homework, however, as funds can be complicated

Jul 10, 2014 @ 11:18 am

By Thomas Hoops

bonds, fixed income, unconstrained bond funds, go anywhere, legg mason
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With equities hovering near all-time highs and baby boomers fueling demand for income solutions, bond investing — yield, capital preservation and risk reduction — is as important as ever. However, given persistent low interest rates, building a bond portfolio that meets clients' needs has never been more challenging.

To achieve income and diversification requirements, investors may need to consider a broader set of sectors and geographies, and potentially take more credit and interest rate risk. Meeting these needs and navigating risk is leading to new strategies and solutions — highlighted by unconstrained bond funds, which can offer savvy investors attractive options.

(On the flip side: Unconstrained bond funds are constraining investors)

Unconstrained bond funds do not adhere to a specific index. As a result, they are not required to own explicit sectors, weightings, markets or credit qualities. This flexibility can be valuable in the search for capital enhancement and income while managing the risk that comes with rising interest rates.

Structural changes in the macro environment also require a more flexible approach. Persistently low interest rates may continue in many developed markets. Sovereign debt is now akin to a credit security, requiring more analysis and global expertise. While low rates are today's issue, we could soon see rate normalization as economic growth gathers pace or through the inflationary effects of central bank monetary policy. Investors who do not manage this rate risk could face losses in their fixed-income portfolios.

To meet these challenges, unconstrained strategies utilize a global investment outlook to take a broad perspective on global segments and sectors. Access to a strong credit research platform can give managers enhanced capabilities to manage credit risk. In addition, managers often utilize portfolio tools to manage interest rate risk, as well as capture relative value opportunities between markets.

GROWING RAPIDLY, POORLY UNDERSTOOD

Lipper Inc. reported that inflows into alternative credit-focused mutual funds (which include unconstrained bond funds) totaled $20.3 billion from September 2013 to February 2014 — significantly more than flowed into many traditional bond fund categories.

Despite this impressive growth, unconstrained bond funds remain a mystery to many investors. According to a recent Legg Mason survey of 500 investors, 64% said they did not understand the term “unconstrained investments.” Among investors over the age of 65 — a core demographic for fixed-income investments — more than 80% did not grasp the term.

“Unconstrained” encompasses a diverse range of strategies, managed without regard to a particular benchmark.

Rather than make investment decisions constrained by the weightings of an index, unconstrained managers often look to maximize the total return of the portfolio given the investing environment, which can be critical in periods of rising rates. The Barclays U.S. Aggregate Bond Index includes longer-dated securities that are more sensitive to rate increases. The index relies on credit ratings, rather than actively analyzing credit fundamentals and contains mostly the largest (and most indebted) issuers.

In an unconstrained strategy, portfolio managers can allocate assets across the universe of global fixed-income securities. Holdings thus often include floating-rate, inflation-linked, non-U.S., private and below-investment-grade securities — sectors that represent nearly 65% of the investible-fixed-income universe. They are absent from most traditional core bond funds, however, since these sectors are not in the Barclays Aggregate index.

Given the focus on reducing interest rate risk, advisers increasingly are allocating to unconstrained bond funds from existing holdings in portfolios that share comparable risk profiles. Advisers also utilize unconstrained strategies to amplify returns without increasing the overall portfolio correlation to equity risk. Each fund addresses a specific objective and some take more risk than others.

Some unconstrained fixed-income strategies have the potential to generate positive returns amid rising rate cycles through the use of derivatives. These strategies also may be able to manage volatility and mitigate the effect of geopolitical unrest.

While removing benchmark constraints, unconstrained funds can actively manage risk through diversification, invest away from U.S. bond markets and use currency as a part of return, offering exposure to different countries and currencies.

Individual funds can meet many investment objectives, including higher return potential that is uncorrelated to equities, long/short market exposures, an absolute return approach and an approach that emphasizes risk management.

And many of these funds offer different return profiles than some other new generation fixed-income products. They can be a true alternative product, used to diversify fixed income, equity and alternative buckets.

FUNDS MUST BE EVALUATED INDIVIDUALLY

It's important to look behind the “unconstrained” moniker, though, as many are not comparable. Advisers and investors need to dig deeper when evaluating these funds but the potential benefits in increased diversification and risk management may ultimately reward the effort.

Investors and their advisers should be sure they fully understand the risks and techniques involved, as unconstrained strategies often use complex instruments that can enhance both gains and losses. When choosing a fund, they should take care to understand what its return objective is and whether it overlaps with existing strategies in the portfolio.

However they are constructed, with the bull market in equities aging, demographics shifting and interest rates low (but poised to rise), unconstrained bond strategies appear to be just getting started. They represent exciting new options for investors seeking enhanced diversification and income within a managed risk portfolio.

Thomas Hoops, is an executive vice president and head of business development at Legg Mason Global Asset Management

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