Wednesday, November 18, 2015
Unconstrained bond fund - the "surprise" rate funds
Unconstrained or "go anywhere" bonds funds are all the rage with investors who have growing expectations that rates are headed higher, but you may more likely call them "rate surprise" funds if you are not careful. These funds have wider mandates than normal bond funds which are often closely tied to the Barclays Aggregate bond index. Clearly, there are diversification benefits from being unconstrained and there are enhanced opportunities for the good rate manager. Buying international bonds, allowing for an allocation to high yield, allocations to preferred stocks, exposure to high dividend stocks and convertibles are all ways to enhance yield in a low interest rate environment. This broadening of the opportunity is a good thing for investors. Traditional bond funds only have duration, credit, and mortgages spreads as the choice set.
Nevertheless, false assumptions of what these funds can do could lead these funds to be called rate surprise funds. They are still likely to lose value in a rising rate environment. They will also likely have more risk in a declining stock environment or a falling economic growth period. Holding securities that are more equity-like will increase equity risk exposure. Holding riskier credits will subject the fund to more business cycle risk. This higher credit exposure is especially true for strategies that are long high yield and short Treasuries to capture only spread risk. The unconstrained funds may also increases exposure to less liquid credits. Finally, strategies that are willing to have negative duration will underperform if there are rate declines. Unless the manager is nimble, these bonds funds will not be safe assets during a crisis period.
We are strong believers in holding credit risk and carry premium at the right time, but research evidence suggests that these both go through cycles and if you think there is potential for an economic downturn, holding unconstrained bond funds will get you something unexpected, principal risk.
Direct allocations to dividend funds or high yield along with managed futures and global macro may be better for investors because the risk premiums are isolated and exposures can be better defined.