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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.
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.
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