Updated Saturday, July 26, 2014 as of 11:12 AM ET
Portfolio - Investment Insights
Taking a Second Look at Unconstrained Bond Funds
Monday, April 21, 2014
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Following a three decades-long bull market in bonds, ever increasing numbers of retirees are seeking additional income from conservatively positioned portfolios. This has led to an increasing number of fixed income fund options with a “go-anywhere” philosophy.

Commonly referred to as “unconstrained” bond funds, these funds comprise a unique and growing category in the normally staid bond mutual fund space; they bear consideration from advisors who are accustomed to selecting fixed income products positioned around an index.

The unconstrained approach, and the flexible options it can create for a fund manager adept at asset allocation, can provide attractive returns. A quick review of the total returns generated by indices representing various segments of the fixed asset class over the past 10 years illustrates this point.

During the past year, higher-risk U.S. corporate bonds—represented by the BofA Merrill Lynch US High Yield Constrained Index—have returned 8.37% as the prospects for highly leveraged U.S. corporations have brightened, and an investor who overweighted this segment of the fixed asset class would have benefited greatly.

Conversely, overweighting the long end of the Treasury curve, represented by the Barclays U.S. Treasury Bond Long Index—which declined 4.90% as the market became focused on the impact of the winding down of the Federal Reserve’s quantitative-easing program—would have proved detrimental.

Over time, higher-risk segments of the fixed income market, such as emerging market debt and high-yield corporates, have generally posted higher total returns. But allocating to them at the right entry point in the credit cycle is the key.

Indeed, a strategy of overweighting high-yield corporates while underweighting U.S. Treasuries, which worked so well this past year, would have turned out quite badly in 2008. That year, the BofA Merrill Lynch US High Yield Constrained Index declined 26.11%, while the Barclays U.S. Treasury Bond Long Index gained 24.03%.

TIMING IS EVERYTHING

To get the timing right, advisors need a solid understanding of how asset classes have behaved historically relative to one another. A correlation matrix, depicting how a diverse mix of fixed income asset classes using broad bond indices as proxies have performed relative to one another over the past 10 years, helps to illustrate.

As you see in the first column of the table, asset classes such as U.S. high-yield corporates, represented by the BofA Merrill Lynch US High Yield Constrained Index, had a correlation of only 0.26 to the broadly diversified Barclays U.S. Aggregate Bond Index fixed income benchmark during the 10-year period ended February 28, 2014. High-yield corporates having a correlation of 1.00 to the Barclays U.S. Aggregate Bond Index, rather than 0.26, would imply that the index generated the same positive total returns during each period as a set of diversified bonds, and vice versa—when diversified bonds declined, high yield would have declined as well.

Because the correlation is not a perfect  1.00 but rather a relatively low one of 0.26—unlike emerging market bonds at 0.64 (represented by the JP Morgan EMBI Global Index) and European bonds at 0.42 (represented by the Barclays Euro Aggregate Bond Index)—during various periods the unconstrained approach may have offered fixed income investors more attractive total return opportunities, albeit with higher credit risk, than an approach that only considered the passively allocated mix of the Barclays U.S. Aggregate Bond Index. So, historically, the opportunities have been there for funds that follow the unconstrained approach. This has recently captured the attention of some advisors and their clients during a period when fixed income total returns have been lackluster.

PREDICTABILITY TRADEOFF

 Since Lipper began tracking the net flows of the alternative credit-focused peer group on September 1, 2013, through February 28, 2014, $20.3 billion net has flowed into the mutual funds (excluding ETFs) within this classification. This compares with $12.4 billion of net outflows from mutual funds within the core bond
classification.

Traditional bond mutual funds, such as core bond funds, are usually “constrained” to a bond index such as the Barclays U.S. Aggregate. This means, according to the funds’ prospectuses, they are generally required to maintain sector overweighting or underweighting within a range relative to the index itself—usually plus or minus 5%-10% of the relevant index. These prospectus constraints also usually apply to the funds’ average credit-quality mix, which is expected to be similar to that of the index.

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