Posted by on Feb 9, 2015 in Blog, Columns, Featured |

By Jason Zweig | 1:53 pm ET  Feb. 6, 2015

Image Credit: Christophe Vorlet

Bond investors, break free.

Such is the clarion call of the fund industry as it promotes what are called “unconstrained bond funds.” The managers of these portfolios aren’t fenced in by the need to mimic the holdings of market averages like the Barclays U.S. Aggregate Bond Index. Instead, they are unleashed to buy whatever seems cheap.

 With these managers free to take an unusually wide range of risks, investors should make sure they aren’t taking on too much risk themselves in buying such funds.

Unconstrained, or “nontraditional,” bond funds took in $79 billion in new money in 2013 and 2014, or more than twice as much as all other bond funds combined, according to Morningstar, the investment research firm.

It isn’t hard to see why. With the 10-year U.S. Treasury yielding less than 2%, barely better than inflation, trying to invest for income nowadays is like trying to find a good plate of prime rib at a vegan food convention. And if the Fed stays true to its word and raises interest rates sometime this year, the future could be even worse. A one-percentage-point rise in rates would cause a 5.5% fall in the price of funds that track the Barclays Aggregate, based on the “duration,” or interest-rate sensitivity, of the index.

With unconstrained bond funds, say portfolio managers, you can do better.

There only are a few ways to beat the bond market: Bet aggressively on the direction of interest rates, profiting on longer-term bonds, for example, if rates remain stable or fall; buy riskier bonds, which will do better as the economy improves; buy bonds that aren’t included in the market benchmark; or buy things that aren’t even bonds.

Unlike traditional funds that hew closely to an index, unconstrained funds may do any or all of that.

The managers of such funds say they are likely to outperform when interest rates finally rise, because they have used sophisticated techniques to reduce vulnerability to that risk. They have replaced it with other sources of return, like the higher yields on less-frequently-traded and lower-quality bonds or the potential to profit from currency fluctuations.

With yields so low, “you’re getting very poorly paid to take interest-rate risks,” says William Kohli, lead manager of the unconstrained $6.1 billion Putnam Diversified Income Trust, “and well paid to take risks in other areas.” His fund is up an average of 5.3% annually over the past five years, not counting sales charges, compared with 4.5% for the Barclays Aggregate. (It lost 36% in 2008 under a previous management team.)

Often, unconstrained funds hold little or no U.S. government debt. Instead, they favor mortgage-backed securities; bonds issued by corporations, including lower-grade “high yield” issuers; or the debt of foreign countries, including such emerging markets as Mexico or Turkey.

Some graze on such nonbond fodder as bank loans, real estate, foreign currency or even U.S. and international stocks.

“We’ve constructed an all-weather portfolio that can perform well across multiple interest-rate scenarios and protect against negative returns,” says Marc Seidner, lead manager of the $10.9 billion Pimco Unconstrained Bond Fund, which is up 2.9% annually on average over the past five years.

At the BlackRock Strategic Income Opportunities Fund, “we’re trying to generate a return of around 4% to 6% a year with low volatility,” says Rick Rieder, lead manager, “so investors can sleep at night and not have to worry about it.” The $27.5 billion unconstrained fund has done just that so far, up an average of 5.6% annually over the past five years.

Some unconstrained funds will undoubtedly succeed. Over the years, a handful of agile fund managers have shown they could outperform the bond market by deviating from it. Among them: Bill Gross, formerly of Pimco, now at Janus Capital Group; Daniel Fuss of the Loomis Sayles Bond Fund; Robert Rodriguez of FPA New Income; and Jeffrey Gundlach of the DoubleLine funds.

But most unconstrained funds haven’t been tested in either a bond-market collapse or a period of sharply rising rates, and the wild freedom of these funds can make their performance hard to forecast. The 16 nontraditional bond funds tracked by Morningstar that existed in 2008 lost an average of 16.8% that year; the Barclays Aggregate gained 5.2%. The next year, the average unconstrained fund gained 19%, or more than triple the return on the Barclays index, as corporate bonds recovered from the financial crisis.

Many unconstrained funds lost money in 2011 as Standard & Poor’s downgraded the U.S.’s credit rating and the European debt crisis worsened. On average, they performed well in 2012 and 2013 but lagged behind the overall bond market by nearly five percentage points last year.

If you had invested $10,000 in the average unconstrained fund at the end of 2007, you now would have $11,253 after fees, compared with $13,859 in the Barclays index, according to Morningstar. You would have had a bumpy ride and ended up behind.

The average unconstrained fund charges 0.84% in annual expenses, or $84 per $10,000 invested; that is 10 times the price of an index fund that owns the entire bond market. Hold such an index fund patiently, and over time the higher income from rising rates will make up for the short-term damage to market price.

Yes, unconstrained funds have a lot of freedom to try beating the bond market. But the same freedom can lead many of them to get beaten by it.

Source: The Wall Street Journal