Unconstrained Bond Funds: Not Worth the Risks

Welcome to MutualFunds.com

Please help us personalize your experience and select the one that best describes you.

Your personalized experience is almost ready.

Join other Individual Investors receiving FREE personalized market updates and research. Join other Institutional Investors receiving FREE personalized market updates and research. Join other Financial Advisors receiving FREE personalized market updates and research.

Thank you!

Check your email and confirm your subscription to complete your personalized experience.

Thank you for your submission

We hope you enjoy your experience

Channels

Find the latest content and information here about the 2019 Charles Schwab Impact Conference.

Advisors

Receive email updates about fund flows, news, upcoming CE accredited webcasts from industry thought leaders and more.

Content focused on helping financial advisors build successful client relationships and grow their business.

Content geared towards helping financial advisors build better client portfolios.

Get insights on the industry trends and investment news from leading fund managers and experts.

Unconstrained Bond Funds: Not Worth the Risks

Bond Funds Image
Faced with a low interest rate environment since the financial crisis of 2008, many investors have begun to seek higher returns than those available from safe fixed-income investments such as Treasuries and FDIC-insured CDs. The ongoing pursuit for higher bond returns has led many investors to investments known as “unconstrained” bond mutual funds (also referred to as multi-sector, absolute return, strategic income and opportunistic fixed income). In 2010, these funds attracted more than $170 billion in assets. In the succeeding four years, assets in unconstrained bond funds rose to $223 million, $275 million, $416 million and $462 million, respectively.

Unconstrained Mutual Funds

Unconstrained mutual funds are permitted to own global bonds, currencies, high-yield bonds, structured bonds and even equities. Many utilize leverage, derivatives and swaps, taking short positions as well as long ones. In other words, in addition to their typically high expense ratios, unconstrained funds are often highly complex. Unfortunately, complexity often carries risks that may offset the very risk-reducing benefits bond investors seek and dilute fixed income’s role as a portfolio’s primary risk-mitigating component.

As one example of the risks involved, Morningstar data shows that as of year-end 2014, the average fund in the “unconstrained” category had 40% exposure to investments rated below investment grade (or that didn’t have ratings). This compares with less than 7% for the average intermediate-term bond fund. What’s more, there isn’t any such exposure in the Barclays U.S. Aggregate Bond Index.

Importantly, unconstrained bond funds have shown a high correlation with other risky assets, even during the post-crisis period of 2010-2014. For example, while their correlation with the Barclays U.S. Aggregate Bond Index was just 0.2, their correlation with the S&P 500 Index was 0.58. And their correlation with risky high-yield bonds and leveraged loans was even higher at 0.86 and 0.79, respectively. We know that the correlations among risky assets will tend to rise toward one another when there are crises, like we had in 2008. Thus, whatever the diversification benefit might be, it won’t be showing up when it’s needed most. In fact, the correlation of unconstrained bond funds with Treasury bonds during the period from 2010 through 2014 was -0.16. And it is Treasury bonds that tend to perform well during crises. Said another way, the correlation of unconstrained bond funds with Treasuries would have been even more negative in 2008.

A Risk Not Worth Taking?

A good example that aptly illustrates the risky nature of these funds is from 2011. Nontraditional bond funds declined 1.3% in 2011, when credit spreads widened as a result of the eurozone debt crisis and a drop in U.S. Treasury yields amid a flight to quality. In contrast, five-year Treasury notes returned 9.5%. That’s an underperformance gap of almost 11 percentage points.

Using Morningstar data, the authors of an April 2015 study — Unconstrained Bond Investing: Too Good to Be True? — examined the performance of unconstrained bond funds over the five-year period from 2010 through 2014. They found that these mutual funds returned 3.4% per year, underperforming the 4.8% return of the average intermediate bond fund and underperforming the five-year Treasury note return of 4.1%.

Investors were paying high fees, receiving low returns and not gaining the diversification benefits provided by safer fixed-income investments. The results would look much worse if the data had included 2008.

Unlike traditional bond strategies, unconstrained bond approaches can invest anywhere (although it may not always be clear where exactly), and the high correlation of their strategies with risky asset classes shows that they negate what I believe is the primary role of fixed income in a portfolio — to dampen the volatility of the overall portfolio to an acceptable level. So, while they do offer higher yields, those higher yields don’t necessarily translate into higher portfolio returns. And, importantly, investors are taking on other risks, risks for which they may not be fully prepared.

The Bottom Line

The bottom line is that unconstrained bond funds belong in the category of products meant to be sold and not bought. There are important diversification benefits to maintaining exposure to more traditional, safer, more transparent and lower-cost fixed income strategies.

Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Popular Articles

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.


Read Next

Bond Funds Image

Unconstrained Bond Funds: Not Worth the Risks

Faced with a low interest rate environment since the financial crisis of 2008, many investors have begun to seek higher returns than those available from safe fixed-income investments such as Treasuries and FDIC-insured CDs. The ongoing pursuit for higher bond returns has led many investors to investments known as “unconstrained” bond mutual funds (also referred to as multi-sector, absolute return, strategic income and opportunistic fixed income). In 2010, these funds attracted more than $170 billion in assets. In the succeeding four years, assets in unconstrained bond funds rose to $223 million, $275 million, $416 million and $462 million, respectively.

Unconstrained Mutual Funds

Unconstrained mutual funds are permitted to own global bonds, currencies, high-yield bonds, structured bonds and even equities. Many utilize leverage, derivatives and swaps, taking short positions as well as long ones. In other words, in addition to their typically high expense ratios, unconstrained funds are often highly complex. Unfortunately, complexity often carries risks that may offset the very risk-reducing benefits bond investors seek and dilute fixed income’s role as a portfolio’s primary risk-mitigating component.

As one example of the risks involved, Morningstar data shows that as of year-end 2014, the average fund in the “unconstrained” category had 40% exposure to investments rated below investment grade (or that didn’t have ratings). This compares with less than 7% for the average intermediate-term bond fund. What’s more, there isn’t any such exposure in the Barclays U.S. Aggregate Bond Index.

Importantly, unconstrained bond funds have shown a high correlation with other risky assets, even during the post-crisis period of 2010-2014. For example, while their correlation with the Barclays U.S. Aggregate Bond Index was just 0.2, their correlation with the S&P 500 Index was 0.58. And their correlation with risky high-yield bonds and leveraged loans was even higher at 0.86 and 0.79, respectively. We know that the correlations among risky assets will tend to rise toward one another when there are crises, like we had in 2008. Thus, whatever the diversification benefit might be, it won’t be showing up when it’s needed most. In fact, the correlation of unconstrained bond funds with Treasury bonds during the period from 2010 through 2014 was -0.16. And it is Treasury bonds that tend to perform well during crises. Said another way, the correlation of unconstrained bond funds with Treasuries would have been even more negative in 2008.

A Risk Not Worth Taking?

A good example that aptly illustrates the risky nature of these funds is from 2011. Nontraditional bond funds declined 1.3% in 2011, when credit spreads widened as a result of the eurozone debt crisis and a drop in U.S. Treasury yields amid a flight to quality. In contrast, five-year Treasury notes returned 9.5%. That’s an underperformance gap of almost 11 percentage points.

Using Morningstar data, the authors of an April 2015 study — Unconstrained Bond Investing: Too Good to Be True? — examined the performance of unconstrained bond funds over the five-year period from 2010 through 2014. They found that these mutual funds returned 3.4% per year, underperforming the 4.8% return of the average intermediate bond fund and underperforming the five-year Treasury note return of 4.1%.

Investors were paying high fees, receiving low returns and not gaining the diversification benefits provided by safer fixed-income investments. The results would look much worse if the data had included 2008.

Unlike traditional bond strategies, unconstrained bond approaches can invest anywhere (although it may not always be clear where exactly), and the high correlation of their strategies with risky asset classes shows that they negate what I believe is the primary role of fixed income in a portfolio — to dampen the volatility of the overall portfolio to an acceptable level. So, while they do offer higher yields, those higher yields don’t necessarily translate into higher portfolio returns. And, importantly, investors are taking on other risks, risks for which they may not be fully prepared.

The Bottom Line

The bottom line is that unconstrained bond funds belong in the category of products meant to be sold and not bought. There are important diversification benefits to maintaining exposure to more traditional, safer, more transparent and lower-cost fixed income strategies.

Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Popular Articles

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.


Read Next