Unconstrained bond funds are constraining investors

The alternative pitched as a way around rising rates isn't holding up it's end of the bargain very well; maybe it's time to look at individual bonds

Jun 17, 2014 @ 8:21 am

By Stephen J. Huxley and J. Brent Burns

Everyone seems to agree that interest rates will rise and it is easy to see why — they simply cannot go much lower. Figure 1 shows the very long term behavior of 10-year Treasury yields back to 1800. The past 30 years or so have provided great returns to bond investments as rates fell from historic highs to historic lows and bond holdings appreciated. But since zero is the bottom line, conventional wisdom is that they must rise in the future (or at least not fall). The big question is — when?

Bill Gross, head of Pacific Investment Management Co., the largest vendor of bond funds in the U.S., doesn't know. As he says, low returns due to rising rates may become the “new normal.” And the specter of rising rates will cause lots of angst among active-bond-fund managers (it already have, including his own). As pointed out in his article, Trevor Hunnicutt suggests many investors are getting restless. Some have seen the handwriting on the wall and have been getting out while the getting is still good.

Why haven't they completely dumped bond funds? The answer appears to be the marketing prowess of bond fund managers. They have been able to stem and sometimes even reverse the tide, at least temporarily. Their efforts include sending out reassurances to existing customers, buying more TV advertising aimed at boomers with retirement income pitches (and probably trying to shut Bill Gross up). They have also cobbled together different kinds of bond funds to pitch.

One of the new fund offerings are alternative or “unconstrained” bond funds. These funds allow the managers to buy almost anything they fancy. The idea is that they can still time the market and predict interest rates, they just need the right tools and latitude to operate. They can invest in derivative products that will allow them to short the market or take other steps using their special gifts of prescience to predict when and how rates will move.

Have they succeeded? The three largest are Pimco Unconstrained Bond A (PUBAX), JPMorgan Strategic Income Opportunities A (JSOAX) and Goldman Sachs Strategic Income A (GSZAX). Since the beginning of the year, they have returned 2.21%, 0.60% and 0.29%, respectively. By comparison, the generic Barclays U.S. Aggregate Bond Index, which includes over 8,000 bonds worth about $17 trillion, gained 3.87%. So the current performance of these new bond funds, with all the new bells and whistles added, is not exactly stellar. They cannot even match their benchmark.


One answer is to follow the smart money and get out of bond funds altogether. Buy individual bonds and hold them to maturity. That way, no matter what happens to rates, the investor will preserve principle and get some interest. Modern portfolio theory suggests holding X% in fixed income but it does not say how it must be held in bond funds. It can consist of individual bonds held to maturity.

For example, if someone wants 40% of their portfolio in fixed income, they can accomplish this by purchasing this 40% as individual bonds and holding them to maturity. If worried about defaults, they can buy the same credit quality bonds their favorite bond fund bought. Once a portfolio holds about 10 or more different bonds, they achieve nearly the same degree of diversity protection as a portfolio with 100 or 1,000 bonds.

Even better, individual bonds can serve a dual purpose. If money must be withdrawn from a portfolio (think retirees), ladders can be built with just the right maturities in just the right quantities to match the desired income flows from coupon interest payments and redemptions. Such portfolios are known as dedicated income portfolios. They offer the advantage of not only meeting the modern portfolio theory edict of X% allocation to fixed income, they also — by holding bonds to maturity — provide a protected stream of secure income, immunized from rising rates or other market fluctuations.

One can only wonder how much financial pain investors (or their advisers) must go through with bond funds before they get the message.

Stephen J. Huxley is chief investment strategist and J. Brent Burns is president of Asset Dedication.


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