The Revenge of Unconstrained Bond Funds

Investors fled the category in 2015, but PIMCO and others are now outperforming and shielding their remaining clients from rising rates.

Illustration by II

Illustration by II

With the rise in interest rates this year and major bond indexes down, one group of fixed-income investors is happy: those in unconstrained funds.

But investors abandoned these funds in droves in 2015 after a bout of poor performance — indeed, just as they were about to turn around. The products are now performing exactly as they were designed to and protecting investors amid rising rates, according to research for Institutional Investor by Markov Processes International.

“As investors are routinely warned, looking at recent performance may not be indicative of future results,” wrote Sean Ryan, senior research analyst at MPI.

“This is especially the case when dealing with funds with shorter histories and newer strategies. That said, between 2010 and 2015, many investors could have dismissed non-traditional bond funds as a high-priced gimmick, delivering no benefit over traditional core bond funds. As the economy recovered and interest rates rose, however, these funds look to have been well positioned to benefit, helping them to outperform since 2015,” Ryan said.

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The funds use a variety of strategies to benefit from or be neutral to rising interest rates. MPI found that the five highest performing funds this year — including PIMCO’s Unconstrained Tax Managed Bond fund and Putnam Diversified Income — are shorting Treasuries, investing in floating rate asset-backed securities, and in leveraged loans. MPI determines a fund’s exposures via its proprietary “dynamic style analysis” tools.

MPI also analyzed the five largest non-traditional bond funds: BlackRock Strategic Income Opportunities, JPMorgan Strategic Income Opportunities, Guggenheim Macro Opportunities, Eaton Vance Global Macro Absolute Return, and Goldman Sachs Strategic Income.

The best performers, as opposed to the largest, had more exposure to tried-and-true offsets for rising rate environments, including floating rate ABS, mortgage-backed securities, and leveraged loans.

The average fund in Morningstar’s non-traditional bond category outperformed the Bloomberg Barclays U.S. Aggregate Bond index by a cumulative 8.35 percent between June 1, 2016 and June 1, 2018. The top five funds, on average, beat the index by 15.56 percent over the same period.

Unconstrained strategies, which Morningstar puts in the non-traditional bond category, first attracted investors who were worried about rising rates. They plowed money into unconstrained funds before 2015. Between 2010 and 2014, assets rose from $16 billion to more than $80 billion in the top 10 products. By the middle of 2014, the number of funds in Morningstar non-traditional category had risen from 25 to 84 in five years, MPI said. Assets likewise doubled from $68 billion at the end of 2012 to $145 billion.

But these trendy products suffered as rates stayed low in the years following the financial crisis. Managers were essentially fighting — and losing to — central banks’ policies, like quantitative easing, for engineering low rates. The funds were positioned for the opposite scenario. Capital flooded out of the products in 2015, just when rates began rising.