Unconstrained bond funds were introduced several years ago, when the industry assumed that investment-grade yields just could not go any lower. Fund managers needed greater flexibility to invest across a wide spectrum of global fixed-income sectors, or so the thinking went.

But after the credit crisis of 2008, yields did continue to move lower, dropping rates past levels previously thought to be all but impossible. At the same time, defaults among lower-quality issuers remained low. Hundreds of billions of investor dollars flowed into all kinds of strategies, many of which posted impressive performance figures.

While there was a short-lived burst of sales of unconstrained bond funds, investors have for the most part shrugged their shoulders at most of these newer strategies. But the start of this year brought with it the sort of conditions that may nudge investors toward these complex portfolios. Since touching the unbelievably low rate of 1.58% in mid-November 2012, the yield of the 10-year Treasury note climbed nearly 50 basis points through mid-February—exactly the sort of weak bond market that unconstrained managers are supposed to be ready for.

Although we should not expect all unconstrained managers to time the market precisely and uniformly, it might be instructive to reflect on their performance in that three-month window to see if in fact the strategies have been as proactive and protective as their sponsors say. Lipper counts approximately 11 unconstrained bond mutual funds in its database. I say "approximately" because an official category for these funds does not exist yet. Instead, the funds we look at here are found in either Lipper's Multi-Sector Income (MSI) or its Absolute Return fund classifications. Most unconstrained bond funds are in the MSI classification, but additional portfolio strategies (like taking short equity positions) are more appropriate to the Absolute Return peer group. (Lipper is still researching Unconstrained Bond Funds as a new classification.)

For the 90-day period when the yield of the benchmark Treasury rose 47 basis points, returns in the unconstrained group of 11 funds were up 1.16%. That outperformed both the Lipper General Bond fund classification average (0.52%) and the very popular Intermediate Investment-Grade Debt fund classification average (-0.17%). Funds in the General Bond group typically own a fair amount of high-yield bonds, the market for which was quite strong in our 90-day window.

But hidden in the average unconstrained fund return were some wildly different results. The managers behind Scout Unconstrained (SUBFX) racked up a return of 4.93% by betting that interest rates would rise and positioning the portfolio with a negative duration—essentially going short on the bond market. Just one other manager could get within 200 basis points of that performance, and that level was just barely reached. This shows that in addition to being unconstrained, short-term success is also a function of being unconventional.

But what of the group in general? As noted, an index of these funds returned a respectable 1.16% in the 90 days after the bond market touched its cyclical low yield (see chart). In that time the Barclays Aggregate benchmark declined 0.82%—a difference of nearly two percentage points and the widest margin of outperformance by unconstrained bond funds since the first quarter of 2012 when they beat the benchmark by 3.08%.

But let's not believe that these funds are bulletproof. Managers behind these funds were caught off-guard in the summer of 2011 when Greece teetered on the brink of default and Treasuries (a sizable component of the benchmark) soared in value. The average unconstrained bond fund lost 1.25% in the third-quarter of that year, way behind the 3.82% surge in the index. Some managers, like the team behind the industry leader JPMorgan Strategic Income Opportunities (JSOAX,) thought they were poised for problems and loaded up on cash instruments; unfortunately, cash couldn't counter the fall in high-yield and foreign debt that sent some portfolios down as much as 4.5%. The lesson here is the same that we learned at the height of the credit crisis three years earlier—in times of financial upheaval, not even diversification can protect all assets.

Despite their vulnerability to economic shocks, these funds provide a reduced risk profile relative to most other bond funds. While the benchmark index has encountered an annualized standard deviation (a projection of one-year volatility) over our look-back period of 1.74%, these funds experienced less than half that volatility—just 0.69%. In 2011, even as these funds fell behind the Aggregate Index on performance, their average volatility was just 2.81% while the index registered 3.78%. Even when they lose, they tend to do it quietly.

Investors who are seeking to mitigate potential losses in a soft market for bonds may yet again turn to unconstrained bond funds. These funds took the advisory business by storm in 2010 when they soaked up $17.1 billion in short order. However, sales fell off a cliff in 2011 during Europe's banking crisis and remained muted as Federal Reserve actions encouraged an extended rally for bonds (last year's net sales were just more than $3 billion).

Should that rally get long in the tooth—and activity so far in 2013 suggests that it is—the better capital protection and nonbond market returns that an unconstrained strategy provides might just find another crowd of interested buyers. Lipper estimates the net flow into these funds was $2.1 billion in January, a clear sign that investors are looking to complement their portfolios with more risk-aware strategies as uncertainties mount in the broader bond market.

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Jeff Tjornehoj is head of Lipper Americas Research, focusing on the United States
and Canada. He is a regular contributor to Lipper's Fund Flows and Closed-End reports.