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An Unconstrained Approach to Fixed Income Investing

The role of fixed income in a diversified portfolio has been a current topic of debate, especially given the uncertainty in the interest rate environment. The majority of traditional US fixed income strategies are benchmarked against the Barclays US Aggregate Bond Index, which is wholly focused on fixed-rate investment grade issues that offer traditionally low yields and longer than average duration. Given the interest rate risk inherent in these strategies at a time when interest rates are starting to normalize, investors have begun to reevaluate their fixed income allocations. An unconstrained bond fund strategy, which has the discretion to invest widely across fixed income sectors and other asset classes without being tied to a specific benchmark, can provide additional sources of returns and greater diversification while helping to shield against undesired risks.

Current Market Environment and Unconstrained Strategies
The Barclays US Aggregate Bond Index, which is the common benchmark for US traditional bond funds, lost 2% in 2013. The major reason for the underperformance was rising interest rates. The lower yields of existing bonds became less attractive as rates rose, thus driving down their prices. The yield on the 10-year Treasury note rose last year to as high as 3 percent from 1.66 percent after three decades of declines. The expectation is that rates will continue to rise, although the timing is uncertain. While many expect that conditions will remain difficult for the bond market, it is widely viewed that unconstrained bond funds can potentially better withstand the headwinds of rising rates. Managers have more tools at their disposal to invest in complex sectors of the bond market, including high yield bonds, bank loans, emerging market bonds and foreign currencies. Many of these sectors, which are excluded from the Barclays Aggregate Index, can offer less interest rate sensitivity and relatively higher yields. As such, unconstrained bond funds have been extremely popular in recent years and have been some of the largest asset gatherers. Unconstrained bond funds saw net inflows of over $50 billion in 2013, which is even more impressive given bond mutual funds in the US posted record investor withdrawals of $80 billion during the year as investors fled fixed income in anticipation of a rise in rates.

Primary Components of Unconstrained Bond Funds
Unconstrained strategies, which are included in Morningstar’s nontraditional bond fund category, are relatively new. The majority of the unconstrained funds tracked by Morningstar were launched within the past five years. The strategies and mandates of these funds can vary widely, and the “unconstrained’ moniker can be a “kitchen sink” type label for a group of funds that is difficult to categorize. In general, however, an unconstrained bond fund is not tied to any benchmark, as the name suggests. PIMCO, which manages the PIMCO Unconstrained Bond fund, has noted that many of these strategies are designed to maintain the primary attributes of core fixed income (diversification versus equities and capital preservation), but with a few significant differences relative to traditional benchmarked portfolios.

First, unconstrained funds are outcome oriented- meaning that they have a goal of delivering positive absolute returns independent of the market environment (as opposed to the relative return focus of traditional benchmarked funds). Additionally, there is a broader opportunity set as compared to traditional benchmarked portfolios. The Barclays US Aggregate Bond Index is comprised of three sectors all tied to US interest rate risk (US securitized, US government, and US investment-grade credit). Unconstrained bond funds, however, can look globally and across all sectors for the best opportunities. And lastly, there is greater flexibility. With the omission of the benchmark, allocations in a portfolio can be made based on the attractiveness of an investment as opposed to the issuance patterns of benchmark constituents. Unconstrained bond fund managers have the leeway in their mandates to focus on what they view as the best bonds for delivering superior returns without benchmark related constraints. (It is important to note that many of these unconstrained bond funds have established limits in terms of exposures. For example, Metropolitan West Unconstrained Bond fund can invest a maximum of 50% of net assets in high yield or emerging markets. According to PIMCO, the limits on certain market exposures, such as high yield and emerging markets, are designed to help maintain overall portfolio quality, limit capital losses and limit correlation with the equity market.) Portfolio managers may take both long and short positions to produce exposure to any level of risk, and, likewise, some managers can utilize derivatives in addition to cash bonds.

The absence of a benchmark also allows for significant flexibility in duration. Normally, a benchmark-based strategy will require the duration of a portfolio to be within a certain band relative to the benchmark (generally, at most, +/- 2 years). As such, most traditional bond strategies are required to maintain a level of positive interest rate exposure that is similar to their market index, even when interest rates are rising. The duration of an unconstrained portfolio, however, can more accurately reflect the manager’s expectations for future interest rates. Managers can tactically limit interest rate risk. Duration can be zero or even negative if the manager has high conviction that bond prices will decline and rates will rise. A typical duration range for unconstrained bond funds is approximately -3 to +8 years.

Risk and Return Expectations
Unconstrained strategies seek consistent, attractive risk-adjusted returns throughout all market environments. Unconstrained investment processes are designed to efficiently budget risk to high quality alpha sources that will provide diversified risk-adjusted returns. Because these approaches are in the early stages of evolution, however, manager guidelines and strategies can vary widely. The lack of a market-based benchmark makes comparison of manager returns and an assessment of risk and return profiles difficult. The appropriate alpha target is dependent on the characteristics of the particular strategy and what the investment universe is. Many unconstrained strategies utilize a spread over a cash-plus benchmark. For example, for a broadly diversified unconstrained portfolio that can invest up to 50% in plus sectors, a target of Libor + 2-4% over a full market cycle could be reasonable. According to Western Asset Management, a portfolio such as this, that seeks to have bond-like risk and return over the long term, but with the absence of a benchmark, could alternatively say that its objective is to generate a return of 5-7% over a market cycle, in line with the long term expectations of fixed income.

Unconstrained strategies typically target market duration bond-like volatility, which has generally approximated 3-7%. Managers expect that although the characteristics of an unconstrained approach could appear to increase the potential for volatility, in actuality, the volatility may be lower because the manager can better diversify the portfolio. That being said, the volatility of an unconstrained bond fund may depend on where the volatility in the market is coming from. If it is interest rate volatility, then the unconstrained bond fund should be less volatile than a total return type strategy. If the volatility comes from credit spreads, however, than the unconstrained portfolio could be more volatile. Also, while an unconstrained strategy protects investors from interest rate risk, this does not imply the strategy is risk free. The strategy replaces interest rate risk with other risks, including credit risk (which encompasses sovereign, emerging markets, currency etc.) and higher active manager risk. Although these risks may be less correlated with the US fixed income market, making the strategy a solid diversifier, unconstrained bond funds can still struggle during a global bond sell off or periods of rate volatility. Moreover, if there is a flight to quality, an unconstrained bond fund could underperform, depending on its positioning, at least in the short term.

Performance
The varied assortment of funds which fall under the unconstrained umbrella, the lack of a market benchmark and the newness of these approaches makes it difficult to assess performance. Performance for unconstrained bond fund strategies generally outpaced broad market benchmarks in 2013, albeit with a wide range of results and no distinct leaning regarding risk, as measured by standard deviation, relative to return. The goal of strong performance regardless of market environments, however, may not have been met by the unconstrained bond fund universe. PEI analyzed the performance of unconstrained bond funds over the past three years, which saw roughly equal periods of falling and rising rates, utilizing the data in Morningstar Direct. Out of the 37 funds in existence with three years or more of history, only 11 out of 37 funds outperformed the Barclays Aggregate Bond Index (+3.75%) over the three year period ended March 31, 2014. It is important to note that the sample size is small, and there is limited historical data given the recent inception dates of these funds. Moreover, the funds included in the Morningstar universe are a mixed bag of “unconstrained” strategies, including strategic and floating income funds. Some large unconstrained bond funds which PEI has examined have demonstrated promising results. The jury is still out with respect to whether or not the asset class overall can meet their investment objectives.

The takeaway with respect to performance is that at this point, the category average cannot tell you much. As unconstrained strategies do not utilize a benchmark index, the funds are extremely varied, and comparisons are difficult. And because the manager’s approach can change quickly given the flexibility in the investment process, historical performance may not be a useful analytic tool. Most unconstrained funds are only a few years old. And given the wide latitude of manager mandates, there is uncertainty with respect to whether successes garnered within such short histories will be repeated. The wide range of performance within the space indicates these funds need to be evaluated on a case by case basis.

Higher Expenses
Unconstrained bond funds are more expensive than the average intermediate term bond fund, in line with the effort it takes for managers to analyze the complexities of the global bond market. Expenses for the group can be much higher than (or more than double) the expenses of traditional actively managed fixed income total return funds. They are, however, in line with the average for the non-traditional and multi-sector group.

Final Considerations
Unconstrained bond funds, which may mitigate the risks of rising interest rates and generate positive returns across varied market environments, are an appropriate consideration given the current low yields of core funds and the expectations for rising rates. An unconstrained strategy can help meet a variety of portfolio goals, including the diversification of risk beyond interest rate risk. Unconstrained funds, however, are much more complex than the typical bond fund many investors have at the core of their portfolio. The introduction of an unconstrained bond fund into a diversified portfolio of investments presents a host of risks, including credit and currency risks. Moreover, these funds can experience short term volatility and a wide range of returns, with higher expenses. While an unconstrained fund could outperform a traditional core/core plus strategy in the current market environment, if conditions deteriorate these strategies may not perform like traditional fixed income. Although the aim of many unconstrained strategies is to provide some of the benefits of a typical bond portfolio (capital preservation, liquidity and income, low correlation to equities), these funds are positioned more aggressively. In a risk-off environment, an unconstrained fund quite possibly would underperform, at least in the short term. As such, an unconstrained strategy should not necessarily be the anchor of a portfolio’s fixed income allocation. Ideally, investors should still maintain a core bond position in their portfolio. In our view, an unconstrained strategy would best serve as a complement to, as opposed to a substitute for, a core/core plus fixed income allocation. Given the nature of unconstrained funds (which shift holdings quickly), it is difficult to estimate how a specific strategy would fit into a broader portfolio and the associated impact on portfolio risk. As such, when evaluating the suitability of an unconstrained fund for a specific portfolio, and the appropriate allocation size, the risk and return objectives for that particular strategy must be assessed.

As noted above, it is important to consider a more diverse set of global opportunities given the modest total return expectations of traditional fixed income portfolios. These varied and more complex sectors of the bond market, however, are difficult to navigate. Utilizing an unconstrained fixed income strategy can be advantageous as this leaves the fixed income asset allocation decisions up to an investment manager who has the flexibility to allocate capital to fixed income sectors that offer solid risk/reward potential while limiting exposure to unattractive sectors. Moreover, these managers can be relatively nimble as the market environment changes. As such, however, the potential benefits of an unconstrained strategy are dependent on the skill set and resources of the management team. It is important to seek a fund that has a tenured team with the expertise to evaluate fixed income opportunities on a global scale and manage the associated risks.