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Go-anywhere bond funds not for the faint of heart

Managers' ability to seek returns in multiple markets sounds great but comes with risks

Apr 22, 2015 @ 5:19 pm

By Jeff Benjamin

The closer the Fed gets to raising interest rates, the better the notion of an unconstrained bond fund sounds.

Why hide out in cash and short-term bond strategies while waiting for higher yields when you can invest in a fund that has the flexibility to go virtually anywhere throughout the $56 trillion global fixed-income market?

That's the theory, anyway. But it's a rhetorical question.

Truth is, the fast-growing unconstrained bond fund category might be attracting a lot of traditional bond fund investors, but it is not and should not be treated as a straight-up replacement for traditional bond funds.

Even in the most basic wrapper, bond math can be complicated. Throw in the flexibility to include international and emerging market debt, corporate and sovereign, everything from high yield to investment grade, including municipal and taxable government debt, plus derivative strategies to adjust duration exposure, and it stops looking like the safe side of the portfolio.

“Conventional bond funds are relatively straightforward in terms of where the risks are, because it's generally around the duration, but unconstrained bond funds are reaching to try and pick up returns in a market that just doesn't have very much return to offer,” said J. Brent Burns, president of Asset Dedication.

COMPLICATED RISKS

“Unconstrained is the term of art in the name, and most investors are not going to be aware of the really complicated risks in those funds,” he added. “They lift all the constraints they have on regular funds and give the managers a free run to basically market time and bond pick.”

The unconstrained bond fund category enjoyed an impressive growth spurt over the past five years as the Federal Reserve's unprecedented monetary policy set the stage for a cycle of rising interest rates.

That reality, which could kick in later this year with the first rate hike since 2006, is expected to have punishing consequences on traditional bond funds and has fueled the popularity of unconstrained bond funds as a means of navigating higher interest rates.

Since 2010, the category has nearly tripled in size, to 117 funds managing $152 billion, up from 42 funds and $56.3 billion. As a broad category, the funds have averaged a 1.3% gain since the start of the year, and 97 basis points over the 12 months through April 21. But the performance dispersion among individual funds this year ranges from a gain of 4.6% to a decline of 3.3%.

The performance dispersion over the past 12 months ranges from a gain of 9.7% to a decline of 8.5%.

Source: Morningstar, Inc.

Notes: 2015 counts through 04/15/2015; 2015 assets through 03/31/2015

“Investors have poured into these funds with the expectation that they will need them in a higher-rate environment, but so far we still haven't seen the higher-rate environment,” said Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ.

Unconstrained bond funds are really just absolute return bond funds, and given their wide-open flexibility, they should be able to thrive in any environment. In other words, if the market favors traditional long-only bond funds, there would be nothing stopping an unconstrained manager from running a portfolio like a traditional bond fund.

But the flexibility that is so celebrated could also be a curse.

“I see unconstrained as a hodgepodge of a lot of different strategies,” said Bradley Alford, chief investment officer at Alpha Capital Management. “Some of the funds are doing long-short credit strategies, and others will be trying to guess on rates by going negative duration. Trying to guess on rates is a loser's game that has never worked.”

Rick Rieder manages the largest fund in the unconstrained category, the $30.2 billion BlackRock Strategic Income Opportunities Fund (BSICX).

In terms of what's driving the popularity of the category, he said, “Fixed income today is a much riskier asset class than it was 10 or 20 years ago.”

WHERE WILL THEY FIT?

That is a fair statement, but it also raises the question of where unconstrained bond funds will fit in a portfolio as traditional bond strategies get riskier with rising rates.

“It depends on what's on the other side of your portfolio,” Mr. Rieder said. “I wouldn't say unconstrained bond funds are going to supplant traditional bond funds, but they will be a significant portion of fixed income portfolios going forward.”

While Mr. Rieder oversees a globally diversified, low-volatility strategy that might even blend in among some traditional bond strategies, the unconstrained universe also includes the $56 million Cedar Ridge Unconstrained Credit Fund (CRUMX).

The long-short credit fund, which led the category last year with an 11.9% gain, is modeled after a hedge fund run by Cedar Ridge Partners and is anything but a proxy for a traditional bond fund. So far this year, the fund is up just 70 basis points

“We tend to run a very active short book, but our Treasury hedges have been a bit of a drag on performance this year,” said Jeffrey Hudson, who manages the 16-month-old fund.

In line with the ballooning universe of liquid alternative funds on the equity side, unconstrained bond funds are gaining appeal for their potential to hedge a seemingly known risk.

“The real test for these types of funds is rising interest rates,” said Gareth Isaac, manager of the Schroder Global Strategic Bond Fund (SGBNX).

“Investors are looking for choices because they don't want to be holding low-yielding duration assets as rates start to rise,” he added. “Investors know that [traditional bond funds] aren't the safe bet they used to be.”

The question is, do investors think unconstrained bond funds are the new safe bets?

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