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Bond investing has never been more difficult, but not for the reasons most investors think.
Yes, the search for yield is still a daunting one. And yes, in that search for yield many investors took on too much credit risk -- the risk of a bond issuer defaulting -- as money poured into junk bonds and emerging-market debt. But the real problem bedeviling most fixed-income portfolios isn't credit risk. It's interest-rate risk.
Rising interest rates make newer bonds -- issued at those higher rates -- more appealing. So investors tend to shun existing bonds in favor of newer issues. That's what happened this summer when rates rose sharply, causing some of the first significant losses in bond funds in quite some time. But investors should be braced for more volatility and more losses. No matter what your goal -- safety or income -- it's time for a new strategy.
"Whatever strategy used to work during a 30-year bull market no longer makes sense in a portfolio today," says Meg McClellan, U.S. head of fixed-income at JPMorgan Private Bank. "It's not going to protect capital, and it's not going to work as an anchor against stock swings."
Fund firms, of course, think they have the solution: the unconstrained bond fund. But whenever the industry seizes on a "solution" to anything, some caution is warranted. "It's really important to recognize that the roots of unconstrained bond funds are marketing-based," says Eric Jacobson, bond-fund analyst at Morningstar. "The driving force behind these funds is that people don't want to take interest-rate risk, and what you very often see here is the exchanging of one risk for another," namely credit risk.
"Unconstrained" is essentially a catchall label for a category of funds that defies easy categorization. Think of them as on the riskier edge of a continuum of bond funds with broad mandates. That begins with core funds, which are well diversified across highly rated U.S. government, corporate, and mortgage-backed bonds, and the specific securities in the portfolio closely resemble those in a broad index, such as the Barclays U.S. Aggregate index. Total return funds -- the poster child for which is the Pimco Total Return fund (PTTAX) -- aim to match certain attributes of a benchmark, such as its yield or its susceptibility to interest-rate risk, but can mix up the actual holdings a bit more. Unconstrained funds, by contrast, don't have any sort of benchmark and are essentially a free-for-all of strategies and holdings.
Despite their youth -- 43 of the 62 nontraditional bond funds tracked by Morningstar were launched within the past five years -- these funds have been some of the biggest asset gatherers, now holding $113 billion in total assets.
While most go-anywhere-type funds are used to give investors some peace of mind, leaving things in the hands of a smart manager, unconstrained funds are so very different from one another that they perversely require investors to be even more savvy than the typical bond investor, not less. Unconstrained bond funds come with an outlook -- the manager bases all of his decisions on where he thinks economic growth and interest rates are heading, and where he spots opportunities for return.
After three decades of falling interest rates, the easy gains in the bond market are behind us. Unconstrained funds allow for more nimble and opportunistic bond investing -- the ability to "make a little bit of money a lot of times," says Rick Rieder, chief fixed-income investment officer at BlackRock. Rieder says this strategy is particularly important in what he expects to be a lengthy period of comparatively low, slow-rising interest rates.
On the whole, unconstrained bond funds are down 0.6% this year, while the main benchmark bond index, the Barclays U.S. Aggregate index, is down 1.8%. The Agg, as it's known, includes large stakes in Treasuries and other highly rated, low-yielding bonds that have been hit hardest as rates have risen this year -- precisely the bonds that many managers today seek to avoid.
But the category average can't tell you much. Because unconstrained bond funds, by definition, don't even give a nod toward a benchmark index, they're wildly different from one another -- which makes choosing one tricky. It's nearly impossible to compare them with each other, since their holdings and strategies vary so widely. Even looking at their own historical performance -- what little of it there is -- isn't very helpful, since a manager's approach can (and arguably should) change on a dime.
Take, for example, the largest fund in the category, the $29 billion Pimco Unconstrained Bond fund (PUBAX). Its minus 1.8% return this year puts it "near the bottom of the pack," says Morningstar's Jacobson. He says the fund had too much in Treasuries when rates started rising, so its performance has been "not awful, but weak relative to other unconstrained funds, and maybe less than what people were expecting in the event of a rate shock."
Sabrina Callin, who oversees Pimco's unconstrained bond products, says that the fund tries to uphold the broad risk profile and diversification benefits that investors associate with traditional bond investing -- such as capital preservation and a low correlation with stocks -- but the unconstrained approach gives it greater flexibility in selecting investments.
In contrast, Jacobson points to the $21.9 billion JPMorgan Strategic Income Opportunities fund (JSOAX), one of the better performers this year, returning 1.9%, versus the 1.8% drop in the index. The fund has been helped by a heavy concentration in junk bonds, which outperformed this year. "It really shone during this period, but it has been pretty highly correlated to the high-yield market," Jacobson says.
So while unconstrained bond funds can play a role in mitigating interest-rate risk, they're not a one-fund solution for your bond portfolio. "They've been marketed as funds for all seasons, and I don't necessarily agree with that," says Jeffrey Kobernick, an advisor and portfolio manager with UBS Private Wealth Management. "This year, they've all been a little disappointing. It's the first year that rates have really moved in the wrong direction, and some still got banged around."
Kobernick uses unconstrained funds as complements to core bond funds, not a substitute. Since 2010, UBS has allocated 25% of its model fixed-income portfolio to unconstrained funds, currently split equally between funds from BlackRock and Goldman Sachs. Still, Kobernick says he's worried that the explosive growth of unconstrained funds makes them less tactical and nimble than they were designed to be.
Clearly, sorting through these funds is no easy task, but Barron's found four worth considering.
Jonathan Beinner manages the $9.9 billion Goldman Sachs Strategic Income fund (GSZAX), whose 6% one-year return tops the nontraditional fund category, with an eye toward mitigating interest-rate risk.
"By far the biggest risk in a core bond fund is interest-rate risk, and the biggest allocations are going to be Treasuries, agency mortgage-backed securities, and high-quality corporate bonds," he says. He prefers high-yield corporate bonds and emerging-market debt, such as longer-dated Mexico bonds. He favors German bonds to comparable U.S. debt, saying that the European Central Bank is further from raising interest rates than the Federal Reserve.
The fund hedges its interest-rate exposure by using interest-rate swaps or futures, which Beinner says takes interest-rate risk out of the equation so the fund can focus squarely on security valuation.
Manager Bill Eigen says that even though his fund (JSOAX) has benefited from the outperformance of the high-yield market, as Morningstar's Jacobson points out, he has no particular fondness for junk bonds. "Any trade we have on is always coincidental and all depends on where value is in the marketplace," Eigen says.
Eigen describes his fund as an absolute return fund, which doesn't follow a benchmark but does employ short positions, pointing out that other unconstrained funds can sometimes be long-only. He says the hedge-fund industry evolved because equity markets experienced periods of both gains and losses, and that the bond market has been comparatively spoiled by a three-decade bull run but needs to adapt. He sees tough times ahead for traditional core-style bond investing from a starting point where yields are still near long-term lows.
"If you really want to be long fixed-income, you better be praying for recession, you better be praying for deflation, you better be praying for the Fed to fail," he says. "And if that's your base case, then I hope you don't own any equities at all."
Tad Rivelle, chief fixed-income officer of TCW, knows a thing or two about the nuances of bond-fund categories. He manages the $24.8 billion MetWest Total Return fund (MWTRX), the $513 million MetWest Unconstrained Bond fund (MWCRX), and the $234 million MetWest Strategic Income fund (MWSTX).
The unconstrained fund has only been around for two years, but Strategic Income leads Morningstar's nontraditional bond fund category with a 6.1% average return over the past three years. The two funds are similar in that they use absolute return–style strategies and are not tied to any traditional benchmark. Strategic Income uses hedges, including short positions, to control volatility, while the unconstrained fund is generally long-only and is designed to produce higher long-term returns with somewhat higher volatility.
"Unconstrained, as a general organizing theme, has a vast amount of flexibility in terms of how it can allocate capital and adjust duration strategy, meaning it can avoid the areas of the bond market that are most risky and can go elsewhere to find safe yield," Rivelle says. "If you're just looking for fixed-income in terms of weathering the storm and getting income, you're swimming upstream if you're just in a core bond fund [or] in any fund that's highly correlated to movements in interest rates."
Rieder, the manager of the $8.6 billion BlackRock Strategic Income Opportunities fund (BASIX), says investors should use unconstrained bond funds as a complement to existing core funds, rather than a substitute, depending on their needs. Pairing this fund with a core fund lets investors reduce both the volatility and the duration of their bond holdings, he says.
BlackRock promotes Strategic Income's ability to shift its holdings quickly and frequently to exploit market conditions, as it did when it moved from a 13% cash position in February to a 57% position by June. Lately, Rieder sees value in commercial mortgage bonds and in the global high-yield market, and says unconstrained strategies let people diversify bond portfolios more aggressively and create income in ways other than adding interest-rate risk. "A lot of people who are in existing core [bond] positions are going to diversify," he says.
Aided by that large cash holding, the fund currently has an effective duration -- the bond market's gauge of interest-rate risk -- of 0.1 years, meaning a 1% rise in interest rates would produce only a 0.1% decline in value for the fund.
It's a particularly defensive position, even by the standards of unconstrained funds, which have been racing to shorten their duration to protect against rising rates.
Sometimes a little constraint isn't so bad.
The appeal of unconstrained bond funds lies in the manager's ability to move in and out of investments quickly, taking advantage of whatever short-term opportunities he sees, without being tied to a benchmark. But not having a benchmark means there's no point of comparison -- which can make it very hard to ascertain how a fund is performing relative to other unconstrained funds, its own history, or the larger category of core bond funds.
It also means it's not a good fund to use as the centerpiece for your portfolio.
"An index sets the broad boundaries for risk and return," says Douglas Hodge, chief operating officer at bond giant Pimco. "An unconstrained strategy has no index per se. There's no anchor that defines the risk."
Yet investors have been yanking money out of more benchmark-oriented total return and core funds, and plowing them into unconstrained and other nontraditional bond funds. The Pimco Total Return fund (PTTAX), for instance, has had five straight months of outflows, with more than $46 billion exiting from the $250 billion fund. When interest rates rose this year, core bond funds "didn't just fall out of favor, they fell out of bed," Hodge says, "and the exodus has been unprecedented."
Not all big bond shops even offer an unconstrained fund. Jeffrey Gundlach, the founder of DoubleLine Capital, has steadfastly refused to launch an unconstrained fund. His firm includes the flagship fund he manages, DoubleLine Total Return Bond fund (DLTNX), which has amassed $35 billion since its 2010 inception. It has returned 6.5% annually over the past three years, beating 99% of its peers. DoubleLine also offers a core fund, a floating-rate fund, a low-duration fund, and an emerging-markets bond fund.
"Unconstrained funds are popular because people don't know what they are," says Gundlach. "They think what bond funds used to do isn't going to work, so now the holy grail is to show me a bond fund that doesn't have any interest-rate risk but somehow has return. Unconstrained funds actually have more risk than total return funds or core funds because they have more aggressive investments."
Like many big bond funds, DoubleLine's Total Return fund (DLTNX) uses the Barclays U.S. Aggregate Bond index as a broad benchmark, but like other total return funds, it doesn't mimic index holdings as closely as a core fund would. While the Agg has about a 37% weighting in Treasuries, the DoubleLine fund has just 5%. More than three-quarters of the fund is in various types of mortgage bonds, which Gundlach sees as a better proxy for the broader bond market.
"Measured against an index, you become more of a security selector," he says.
Even some core-fund managers who are skeptical of unconstrained funds have a hard time making a case for core funds today. "The problem is that a core fund right now isn't providing you a very high level of income, and if rates rise, it will not provide a lot of protection," says Krishna Memani, chief fixed-income investment officer at OppenheimerFunds. He says investors looking for core-type exposure are better off in a high-grade corporate-bond fund, and investors whose main worry is rising interest rates should look at bank-loan funds -- which invest in loans made to indebted companies and offer floating interest rates -- as a better bet than either core or unconstrained funds.
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