All-weather bond funds sacrifice traditional benefits of core

As in times past, an ample number of surprises and volatility in financial markets around the globe were unleashed in October. This environment also offered investors some important remedial lessons on the virtues of a core fixed-income allocation within a diversified investment portfolio.

To be sure, investors have been suffering through an extended low-yield environment fostered by an ultra-accommodative domestic monetary policy and a below average economic recovery. In this low-yield, late-cycle environment, many investors have been turning to unconstrained bond funds for added yield, higher returns and as a defense against the potential for higher interest rates.

The intention is good. Unfortunately, too many vehicles that market themselves as all-weather fixed – income choices sacrifice the traditional benefits of owning core fixed income in the first place.

It’s easy to forget, but the main reasons to own core fixed income, aside from the income itself, is to provide a comparatively stable principal value, relatively predictable returns and risk diversification versus stocks. When combined with equities and other asset classes, high-quality fixed income improves portfolio-risk-adjusted returns. Investment-grade bonds bring a desirable combination of low volatility and negative correlations relative to stocks. That’s their role on the investment portfolio team.
Alternatively, unconstrained bond funds historically have demonstrated much less predictable returns than traditional fixed-income choices and recent performance has remained true to that pattern. In that way, their returns often are more comparable to income equities rather than bonds.

Two key investment consequences are increasingly evident in the data.

First, high-beta bond funds tend to underperform when equities underperform. They amplify volatility rather than reduce it. Moving from high-quality fixed income to equity-like fixed income increases portfolio volatility. Second, unconstrained funds tend to be less efficient diversifiers of equity risk than high-quality bond funds.

Sure, holding high-quality fixed income represents an opportunity cost, especially when interest rates are low and during equity bull markets. The opportunity cost is measured in the form of forgone returns.

However, we think of temporary low returns as a sort of premium on an insurance policy that pays off when equity markets sell off and high-quality fixed income outperforms. Many unconstrained and equity-like bond choices simply don’t stand up during equity market weakness.

So, if their returns are unpredictable and their diversification benefits are questionable, why own unconstrained bond funds? When making fixed-income choices, most investors should look for diversification, not amplification.

Robert Smith is president and chief investment officer at Sage Advisory Services.