Unconstrained bond funds, which were designed as a result of the 2008 financial crisis and became popular soon after that, seem to have met the demand for yield from investors and the advisors who manage their money.
By removing the traditional restrictions around what a fixed-income fund can invest in (such as bond ratings, currency and sectors), these unconstrained funds sought to increase returns for investors who were comfortable taking more risk.
But as interest rates normalize — especially on the lower end of the curve — does this approach still have a purpose?
First, a little background. In April 2007, the U.S. Treasury yield curve slightly inverted when interest rates were 5.04% for a 3-month bill and 4.84% for a 30-year bond. In yield curve analysis, this omen seemed to predict a recession, and as we know now, what followed was unprecedented. Fast forward to April 2011, and the yield curve normalized again, albeit low on the axis thanks to the Federal Reserve’s quantitative easing policy and near-zero interest rates: 0.08% for a 3-month bill and 3.08% for a 30-year bond.
Fixed-income investors and advisors alike were scrambling for yield and trying to find it places other than traditional bonds. Along came unconstrained bond funds. They took the approach of melding various different sectors of fixed income, combining domestic bonds, international bonds, long-short positions and derivatives. According to Morningstar, the amount invested in these bond funds more than tripled between 2011 and 2014, with flows remaining steady since then.
How were they used? In my conversations with various advisors, the approach to unconstrained bond funds has been mixed. Advisors seeking a more traditional approach have largely stuck with corporate and Treasury bonds and explained to clients that finding yield in the current climate will be limited. Thankfully, equity returns have balanced this loss of yield for many investors. However, for advisors not wanting to give up yield, unconstrained funds have been a welcome alternative.
For colleagues who were providing active fixed-income strategies to their clients, adding another tranche to their approach and attempting to provide additional returns was a welcomed strategy. Explaining this approach to clients, however, was a bit tricky. Understandably, some clients resist the idea of giving a fund manager a carte blanche with their money. Fear of the unknown, especially given that these funds were new to the market, was a common objection.
To ease these concerns, advisors have been using these funds in conjunction with more traditional offerings. By slimming down their exposure to Treasury and high-grade corporate approaches, this unconstrained approach has been used alongside foreign fixed-income. In my discussions, advisors were allocating between 5% to 10% of their client’s portfolios to this unconstrained position.
QuoteIn my discussions, advisors were allocating between 5% to 10% of their client’s portfolios to this unconstrained position.
Has this approach worked and does it apply to today’s fixed income market? If you look at the return objectives of these funds, they are not geared for short-term gains, which seems strange given how they came into being and have been positioned to clients. However, over the period they have been available, the returns have been largely determined by the manager of the fund and the fund’s specific approach.
For example, as of the end of second quarter in 2018, PIMCO’s Unconstrained Institutional Class bond fund (PFIUX) has a 5-year annualized return of 2.57% and a TTM yield of 5.21%. In contrast, Deutsche Fixed Income Opportunities Institutional bond fund (MGSFX) has a 5-year annualized return of 1.40% and a TTM yield of 2.80%. Given the wide range of approaches that these funds can take, being aware of the approach of the bond fund at all times is an important factor for advisors.
When comparing the characteristics of these funds with their traditional counterparts, they have been a good choice as yields have been low. But now short-term yields have been climbing, they start to look less and less attractive given the risk it requires to achieve these returns. For example, a one-year Treasury bill now provides a 2.3% yield, which is close to what the lowest performers in this market are achieving. Given the different risk profiles of these positions, it’s starting to make more sense to move back to safer assets to remove the credit risk from the investor.
The timing of a return to traditional fixed income: But how should the move back to traditional investments be timed? Moving too early will get clients caught up in a losing game of declining fixed-income asset values if they own funds and interest rates continue to climb. But waiting for too long could open up clients to too much credit risk in an unconstrained fund. They may also be able to earn a similar return in high-grade corporates and Treasurys.
Given the current yield being generated by high-performing unconstrained funds, the move might be hard to justify at this time, but once interest rates have returned to their normal levels, I think the unconstrained funds will fall out of favor.