Are unconstrained bond funds an antidote to rising rates?

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As advisors evaluate fixed-income opportunities for clients as interest rates rise, they might want to take a look at go-anywhere or unconstrained bond funds.

These funds can purchase any kind of bond in any geographical area.

Investors flocked to the funds immediately after the financial crisis, but their hopes weren’t met with stellar returns.

“As a result, a lot of people soured on them,” says Karim Ahamed, investment advisor and partner at HPM Partners in Chicago.

“That’s too bad, because in this environment, they could be very beneficial,” he says. “An uncertain economic environment with rising rates augurs well for unconstrained strategies.”

As for the mediocre returns, open-end mutual funds and exchange-traded funds in Morningstar’s nontraditional bond category generated annualized average returns through May 16 of 1.9% for the year, 2.5% for three years, 1.7% for five years and 3.5% for 10 years. There are 338 funds in the classification.

But the potential is there for better performance, observers say.

“For people with the fortitude to stick around, their patience will be rewarded,” Ahamed says.

“These funds have an ability to harness sources of return that may not be available to traditional benchmark strategies,” he says. “For example, the ability to go short could provide protection.”

The fund that HPM has used, Goldman Sachs Strategic Income Fund (GSZAX), and many of its brethren were early in betting on an increase in long-term rates. But, of course, long-term rates didn’t advance far until recently.

“So, the strategies got hit,” Ahamed says. “But I would expect they will come into their own when rates rise sharply.”

Ahamed isn’t the only one who sees value in the funds.

“I’m a big fan,” says Ethan Anderson, a senior manager and advisor at Rehmann Financial in Grand Rapids, Michigan.

The funds can use all kinds of different strategies around the yield curve, he says.

“If you’re looking for a better story of how to add value, and believe in what the managers are doing, then it’s good to give them leeway,” Anderson says. “If it’s a good management team, there’s nothing wrong with giving them more flexibility.”

But first examine the fund’s strategy carefully.

“Is it just a high-yield fund in sheep’s clothing?” Anderson asks.

“I don’t want a dedicated high-yield fund,” he says. “I want a manager who knows when to have high yield and when not to have it.”

Anderson also stressed the importance of choosing funds with track records of at least 10 years, so as to see their performance in both up and down markets.

This story is part of a 30-30 series on evaluating fixed-income opportunities when rates are rising.

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