Unconstrained Bond Funds: Finally Being Tested

Rock-bottom interest rates have left many bond investors hungry for competitive yields on their money, and when the Fed finally signaled that it was going to start raising rates again, lending institutions everywhere rejoiced. But rising interest rates also mean falling bond prices, so those who are holding fixed-income securities in the secondary market need to prepare themselves for some possible capital losses.

However, a new type of bond fund has appeared in recent years that is able to go places that other bonds funds can’t. Unconstrained bond funds do not have the normal limitations on the types of securities that they purchase like their conventional cousins. They've been pitched as a way to hedge interest rate risk and they've grown to 131 funds and almost $135 billion in assets from just 27 funds and $9.2 billion in 2008. But the jury is still out on how well these funds really perform. Sure, the funds have seen significant inflows over the past six years, but 2015 saw $16 billion in net outflows as the category posted a 1.41% average decline. Investors and financial advisors discovered that they would have been better off in short-term government bonds or preferred stock funds.

As the name implies, unconstrained bond funds are not constrained to investing only in a particular sector of bonds, such as government or corporate. They in fact can be compared to the new non-formatted radio stations that do not adhere to a specific type of music and play hard rock, country, pop, hip-hop, new wave and softer music.

Unconstrained bond funds can likewise invest in government, municipal, corporate and foreign bonds of any denomination and issuer and with any rating or level of risk. This allows the fund manager to reallocate fund holdings in accordance with the markets and provide a more constant return for investors. These funds likewise do not measure their performance against specific bond benchmarks such as the Barclays Capital Aggregate Bond Index. Some unconstrained fund managers even short bonds in order to profit from declining prices. These diversions from the boundaries normally found in conventional bond funds can mean great opportunity (and great risk) for investors. But ideally, a skilled unconstrained bond fund manager would be able to add value by actively allocation fund money across several broad sectors of fixed-income instruments.

Unlike many bond funds, unconstrained funds may be able to provide alpha from active management and a sufficiently broad array of offerings. They may also be able to reduce or eliminate interest rate risk by investing in holdings that have shorter durations than core bond funds are allowed to hold. Obviously, this could be a significant advantage if interest rates start to rise.

Although unconstrained funds may be able to do anything, so to speak, they come with some substantial risks that investors should understand before getting into one of these funds. Some of the risks that come with a lack of constraint include:

• High credit risk – Many unconstrained funds have used their freedom to load up on junk bonds and other high-risk debt in order to achieve higher returns and improve their track records. But this practice can backfire, as any issuer in the fund that defaults can substantially lessen the returns posted by the fund.
• Relatively short histories – Unconstrained bond funds comprise a relatively new entrant into the financial marketplace. Most of these funds have very short historical track records and have not had the chance to experience many different types of market conditions, such as higher interest rates. No one really knows for sure exactly how these bonds might perform when rates start to rise. And historical performance here doesn’t count for as much as it would with most other types of funds anyway, because these funds have the freedom to behave completely differently under the same market conditions in the future.
• High expenses – Unconstrained bond funds often have higher sales charges and annual fees than other types of bond funds because they may require a higher level of data analysis and research than other types of funds that focus on only one or two types of securities. A typical nontraditional bond fund (of which unconstrained funds are a subsegment) has an annual expense ratio of 1.31%, while an average bond fund with intermediate-term holdings has an average expense ratio of just under 0.9%.

Unconstrained bond funds enjoyed an inflow of billions in investor capital in 2015 as rising interest rates loomed on the horizon. But it remains to be seen how well these funds perform as rates start to rise. While they are able to move in almost any direction, the question will be whether there is any good direction that they can go. This subsector of the bond market is growing rapidly, and investors need to do their homework and look at the historical track records of the fund managers before making a purchase. The risk-adjusted returns that are posted by these funds are probably going to be more important than absolute returns by themselves.