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June 16, 2014

Unconstrained Bond Funds: An Increasingly Popular Way to Seek Total Return

by Lipper Alpha Insight.

Products focused on income solutions are undeniably in demand, largely as a result of both the macro fixed investing environment and shifting demographics. Following a three-decades-long bull market in bonds, the search for fixed income yield remains in full force as does the demand for higher total returns. This dichotomy is set against a backdrop of an ever-increasing number of retirees seeking additional income from conservatively positioned portfolios. Yield compression, and the resulting bond price appreciation that accompanies it, has added to this income solution challenge for advisors by reducing the number of attractive capital appreciation opportunities available in fixed income. These considerations have converged to help create an increasing number of fund options that have a “go-anywhere” philosophy in the fixed income asset class. These products are often also referred to as “unconstrained” bond funds.Foreign exchange dealer walks past graph showing movements of U.S. dollar and Japanese yen exchange rates in Tokyo

The unconstrained approach, and the flexible options it can create for an experienced fund manager adept at asset allocation, can potentially provide attractive total returns. A quick review of the total returns generated by indices representing various segments of the fixed asset class over the past ten years illustrates this point. During the past year (ended February 28, 2014) higher-risk U.S. corporate bonds, illustrated by the performance of the BofA Merrill Lynch U.S. High Yield Constrained Index, have returned 8.37%; these companies had been in favor as the prospects for domestic highly leveraged corporations had brightened. An overweighted allocation to this segment of the fixed asset class would have benefited an investor greatly during this period. Conversely, an overweighting to the long end of the Treasury curve, represented by the Barclays U.S. Treasury Bond Long Index—which declined 4.90% as the market became focused on the impact of the winding down of the Federal Reserve’s quantitative-easing program—would have proved to be quite detrimental.

Over time, higher risk segments of the fixed income markets, such as emerging markets debt and U.S. high yield corporates, have generally posted the highest total returns; however, allocating to them at the right entry point in the credit cycle is key. For example, the overweightings to U.S. high-yield corporates and underweightings to long U.S. Treasuries that worked so well over the past year (ended February 28) would have had quite the opposite impact on a portfolio’s total return if they were taken by a fund in 2008. The BofA Merrill Lynch U.S. High Yield Constrained Index declined 26.11%, while the Barclays U.S. Treasury Bond Long Index gained 24.03% for 2008.

Table 1. Cumulative Total Returns as of February 28, 2014


Results such as these necessitate that an advisor has a solid understanding of how asset classes have historically behaved relative to one another and that the advisor strongly considers the potential fund firm’s breadth of experience in managing a diverse range of fixed income assets. A review of a recently compiled correlation matrix of how a diverse mix of fixed income asset classes, using broad bond indices as proxies, have performed relative to one another over the last ten years helps to illustrate. It shows how not only having a wide range of diverse assets that can be tactically used will add diversification but also how—when used by a successful tactical allocator—it can generate attractive total returns.

Table 2. Fixed Income Asset Correlations, February 2004-February 2014


As can be seen in the first column of Table 2, asset classes such as U.S. high-yield corporates, represented by the BofA Merrill Lynch U.S. High Yield Constrained Index, had a correlation of only 0.26 to the broadly diversified Barclays U.S. Aggregate Bond Index fixed income benchmark during the ten-year period ended February 28, 2014. High-yield corporates having a correlation of 1.00 to the Barclays U.S. Aggregate Bond Index rather than 0.26 would imply that the index was generating the positive total returns during each period that a set of diversified bonds was, and vice versa–when diversified bonds were declining, high yield would have as well. Because there is not a perfect correlation of 1.00 but rather a relatively low one of 0.26—as have emerging market bonds at 0.64 (represented by the JP Morgan EMBI Global Index) and European bonds at 0.42 (represented by the Barclays Euro Aggregate Bond Index), the unconstrained approach may have offered fixed income investors more attractive total return opportunities—albeit with higher credit risk—during various periods than an approach considering just the passively allocated mix of the Barclays U.S. Aggregate Bond Index. So, historically the opportunities have been there for funds that follow the unconstrained approach. And, this has recently captured the attention of some advisors and their clients during a period when fixed income total returns have been lackluster.

Since Lipper began tracking the net flows of the alternative credit-focused peer group on September 1, 2013, $20.3 billion net has flowed into the mutual funds (excluding exchange-traded funds [ETFs]) classification through February 28, 2014. This compares to $12.4 billion of net outflows from mutual funds within the core bond classification.

Figure 1. Alternative Credit-Focus and Core Bond Mutual Fund (ex-ETFs) Monthly Net Flows, September 2013-February 2014

Unconstrained Slides Figure 1

Traditional bond mutual funds, such as core bond funds, are usually “constrained” to a bond index such as the Barclays U.S. Aggregate. This means that, according to the funds’ prospectus, they are generally required to maintain sector overweightings or underweightings within a range relative to the index itself—usually approximately plus or minus 5%-10% that of the relevant index. These prospectus constraints also usually apply to the funds’ average credit-quality mix, which is expected to be similar to that of the index. Unconstrained bond funds have no such constraints—a key difference for advisors to bear in mind when considering unconstrained bond funds. The lack of these constraints may give pause to some advisors who feel their clients’ portfolios need to have allocations across each standard fixed income “bucket”—duration, quality, or maturity. These advisors may want to consider using unconstrained funds in a smaller allocation with overall portfolio diversification in mind or for the more aggressive segments of portfolios for clients who are comfortable with a goal of higher expected total return at the expense of more unpredictable asset allocations.

To illustrate the diversity of asset allocations within this sector a closer look at two funds in the segment may be useful. Mainstay Unconstrained Bond Fund (MASAX) is a fund that had at year-end 2013 a heavy allocation to domestic corporate (60.2%) and foreign corporate bonds (14.6%), with an additional allocation to loans (8.4%) and convertibles (2.6%). The fund returned 3.89% for 2013, while the Barclays U.S. Aggregate Index declined 2.02%. Another popular offering in the category is PIMCO Unconstrained Bond Fund (PUBAX). This fund has a more diverse allocation, with U.S. government securities (19.0%), mortgages (15.0%), domestic corporates (11.0%), non-U.S. developed governments (13.0%), and emerging markets debt (5.0%) in its allocation mix as of February 28, 2014. This fund declined 2.60% for 2013. Neuberger Berman recently launched its Unconstrained Bond Fund (NUBAX) in February 2014, and it will be interesting to view in the coming months how a newly launched product that follows this objective will be positioned, particularly since it is anticipated more offerings are soon to come from other fund complexes.

Unconstrained bond funds are a unique and growing fund development area in the normally staid bond mutual fund space; these funds bear consideration by advisors who are accustomed to selecting fixed income products that have traditionally been positioned around an index. Advisors who are open to updating their views on fixed income allocations may want to take another look at unconstrained products, since the macro tailwinds from both the demand side remain strong—as more investors seek total return—and on the supply side—as more investment managers gain expertise with the approach.



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