The below article is a synopsis of a recent discussion between Morningstar.com editor Jason Stipp and Morningstar director of fixed income research Eric Jacobson.
An Unconstrained History
If you haven't heard of an "unconstrained bond fund" you probably will soon—this set of funds is increasingly gaining investors' attention, but the idea behind an unconstrained bond fund isn't entirely new. If you look back in history you won’t find any funds with this name but that doesn’t mean these kinds of strategies haven’t been used before. Back in, say, the 1980s, the more "plain-vanilla" bond funds often entailed a flexible approach, not so much in terms of the sectors that they invested in but certainly in terms of their interest rate sensitivity. Flexibility is the key when it comes to the meaning of ‘unconstrained’ in this context.
This trend for a high level of flexibility in fixed-income fund management in the 1980s fell out of favour with investors the following decade. In 1994, after a long period of falling interest rates, rates suddenly reversed their trend and started on a sudden and steep climb that led to the devastation of a lot of these types of flexible fixed-income funds. There were severe repercussions and even managers who had advertised themselves as ‘all-weather’ managers turned out to have not really been so ‘weathered’. This changed the landscape of the industry and a number of firms at that point began looking at how they managed interest rate sensitivity across an entire swath of their fund lineup. Fidelity, for example, at that time then linked all its funds' interest rate sensitivities to benchmarks.
Unconstrained Isn’t the Same as Go-Anywhere
Now this trend is re-emerging under the ‘unconstrained’ label. It’s important to note that the flexibility these fixed-income funds adopt doesn’t necessarily mean that their managers are truly go-anywhere managers. The ‘unconstrained bond’ category is still developing—it hasn’t yet gelled into what one might think of as a permanent state, but the core group of funds that are starting to stake out this territory certainly do have a lot of latitude to place their bets where they wish. For example, one large fund in this arena is the PIMCO Unconstrained Bond fund. The fund can go negative three years in terms of its duration, or interest rate sensitivity, and as long as positive eight years. That is really a wide range. And the fund’s sector palette is also extremely broad, with the managers able to invest up to 40% in high yield, up to 50% in emerging markets and up to 35% in foreign currency exposure.
Given that there are a lot of clouds on the fixed-income horizon, the clearest motivator for the return of this fund style is that there has been a lot of fear in the marketplace about rising interest rates, which is becoming more acute as we move forward. But it’s not only fear of interest rates that’s spurring demand for these types of products, it’s also the idea of being able to invest in a multitude of different sectors and markets in order to pick up extra income and, essentially, beat the market.
Due Diligence Is Paramount
Managers of such funds got slammed in the 1990s when rates turned higher, which raises the question of whether history could repeat itself if interest rates move in an unanticipated direction. Not every manager is necessarily going to be an expert interest-rate caller, or have all the right decision-making prowess to be in the right sectors when rates turn, so this is certainly something to be aware of. By and large, the returns over the last couple of years on some the larger funds in this area are not all that impressive, because the funds have been very conservative as that's what people are looking for right now in terms of interest rate sensitivity. Considering the breadth of what these funds’ managers can do—and what they are saying they will do over the full market cycle—there is potentially a lot of risk in the category due to the marriage of a tremendous amount of freedom with some potentially very high-risk sectors and interest-rate calls.
Due diligence, therefore, is paramount if you're looking at these funds. A key starting point if you think you’re interested in an unconstrained bond fund is to look at the prospectus and find out what kinds of parameters the fund is dealing with in terms of its interest rate sensitivity or what kind of sector exposure it can take on. Such parameters can be very broad, as already described, and if that's the case you need to decide if you are comfortable with that level of risk-taking. The next step would be to get some sense of who the management team is that's running the fund and ensure you’re comfortable with them. This hard to do as an individual investor but that’s part of our job here at Morningstar. In addition to those who will be deciding the fund’s interest rate sensitivity and macroeconomic calls, it’s also important to get a handle on the underlying teams who will be running the fund’s sleeves—dictating the investment in particular sectors that the lead manager may want to go in to. Whether it's high-yield, emerging markets, foreign sovereigns, we need to have a strong sense that these analysts also have really good capabilities.
This group of funds still has a little bit to prove given that it's still emerging, but there are a few management teams on our radar that we think have a good shot at success. We’re not at the point yet where we're really comfortable making a strong recommendation on any of them, but we certainly have identified a few where we know the teams and their potential.
One fund that comes to mind, which we’ve already mentioned, is PIMCO Unconstrained. The lead manager, Chris Dialynas, is a long-tenured veteran at PIMCO, although a lot of people don't know him because he's been running institutional money. Dialynas is a member of the investment committee and he relies heavily on the sensibilities of his colleagues: Bill Gross, Mohamed El-Erian, and other proven investment minds at PIMCO who have a lot of very strong macroeconomic moorings. We also feel comfortable with PIMCO’s underlying teams’ expertise.
Where Do These Fit In My Portfolio?
How to incorporate an unconstrained fund into a portfolio is one of the most interesting questions you can ask. Unfortunately there’s no defining answer as yet because the sector is still developing and it’s one that entails a huge amount of flexibility. The most suitable approach is to think of such a fund as an add-on to your portfolio, particularly until you have a strong sense of the universe that the fund is most likely to occupy most of the time. By and large, they should probably play a satellite role rather than a core fund role, although it appears that many investors are in fact replacing their core bond fund with an unconstrained offering because they are so fearful of rising interest rates. However, over the longer term, it’s probably advisable to have a little more predictability in your bond portfolio—if you put all your eggs in one basket by dumping your core funds and buying an unconstrained fund, the predictability of your portfolio is going to be a lot lower than it might otherwise be.
As this category grows and develops, we’ll be keeping an eye on the offerings and checking in with management teams to ascertain which types of investors could benefit from a move ‘back to the future’ of flexible fixed-income investing.
