How to find the best nontraditional bond fund

One of the many byproducts of historically low interest rates and the higher risk in traditional bond funds that comes with it is the newfound popularity of nontraditional bond funds.
But as the category has grown to $145 billion across 84 funds, up from $67 billion across 25 funds five years ago, it’s time to start taking a closer look at some of the risks and opportunities developing around these strategies.
Raman Srivastava, manager of the Dreyfus Opportunistic Fixed Income Fund (DSTAX), says investors should pay attention to fund size, look for bond-picking strategies and not be turned off by derivatives.
“The main risk of traditional fixed-income funds is interest rates, but with unconstrained funds there’s less rate risk imbedded in them,” he said. “The whole point of unconstrained is not just to invest in government issues, but the other parts of the market don’t have as deep of issues. It’s difficult to say what is too large, but a smaller asset base makes bond selection more relevant.”

InvestmentNews: Why should investors be interested in unconstrained bond funds if interest rates rise?
Mr. Srivastava: For the past couple of decades, fixed-income returns have been driven by falling rates. The major risk in a lot of fixed-income funds today is rate risk. Investors right now are not getting paid to take on that risk.

InvestmentNews: What type of impact do derivatives have on these types of nontraditional bond portfolios?
Mr. Srivastava: What scares people about derivatives is you can potentially take on leveraged positions. It can be a scary proposition if used incorrectly. But derivatives are an important part of these funds for certain types of exposure and risk management. But derivatives can still only get you so far. Bond picking still matters.

InvestmentNews: What type of investor is best suited for unconstrained bond funds?
Mr. Srivastava: It depends on the overall portfolio makeup. But at this point in the cycle, considering most investors are holding core fixed income, unconstrained bond fund exposure balances the other risks you could be taking in fixed income.
InvestmentNews: Why are these types of funds gaining in popularity?
Mr. Srivastava: It’s driven by a search for fixed income without the duration risk, as people look for a way to diversify against the main risk in fixed income. The challenge for investors now is to realize this has been a good place to be, but what has worked over the past as three to five years may not be as powerful going forward.
A key question for investors to be asking are how a portfolio manager intends to deliver the returns they’ve become accustomed to [in nontraditional bond funds].
In my opinion, there are three main things to look for in a strategy: It needs to be able to move tactically across all parts of fixed income. You have to be active.
Secondly, security selection will be much more important than in the past.
And finally, you have to have the right tools to be able to manage risk, because you have to be able to take risk up and down.
InvestmentNews: How can a financial adviser best evaluate an unconstrained bond portfolio?
Mr. Srivastava: You want it to exhibit bond fund characteristics, including safety and liquidity. You should also look at correlation to other betas. You ideally want a portfolio manager that doesn’t exhibit high correlation to other beta risks. And consider how it will work in the environment going forward, and a lot of that has to do with manager communication.