Rising interest rates can make bond investors nervous. That’s because when rates rise, the prices of previously-issued bonds generally fall. Why? There’s less demand for those bonds since their fixed rates are lower than the rates offered by new bonds in a higher interest rate environment. This is known as interest rate risk.
Concern about interest rate risk, in recent years, led to the rise of one type of bond-related product: unconstrained bond funds. Unconstrained bond funds, also known as nontraditional bond funds, generally aim to reduce exposure to interest rates, among other risks, and give investors flexibility in their fixed income portfolio. But to do so, such funds generally take on other risks and rely on the investing acumen of the fund manager.
“In order to maintain some sort of competitive posture most of those funds, while cutting back on interest-rate risk, have taken on some other kinds of risk,” said Eric Jacobson, a senior fixed income researcher at Morningstar. “Generally, some sort of credit risk.”
The amount invested in unconstrained bond funds more than tripled between 2011 and 2014, to a peak of about $160 billion, amid a high degree of investor concern about rising rates. But in recent years, the sector has seen outflows, with total assets sitting closer to $105 billion in October 2016, according to Morningstar.
Indeed, enthusiasm waned even after the Federal Reserve finally raised its benchmark fed funds rate in December 2015 for the first time in more than seven years, resulting in minor actual moves in various bond markets. At the same time, unconstrained bond funds have underperformed in comparison to an array of other fund types. The average three-year return of unconstrained bond funds is 1.95 percent, lower than nine of the 16 types of taxable bond funds tracked by Morningstar.
It remains to be seen if the anticipation of another interest rate hike by the Federal Reserve will renew enthusiasm for nontraditional bond funds and, should the hike occur, if their performance improves. But before you consider investing, here are five things to keep in mind:
Duration is a metric used to a measure a bond investment’s sensitivity to rising interest rates. The higher an investment’s duration, the higher the interest rate risk associated with that investment. Unconstrained bond funds are known for including a mix of investments that could make their funds less sensitive to rising rates.
Maintaining competitive returns while managing interest rate risks means that the portfolio managers of unconstrained bond funds may accept other risks. A fund, for instance, may invest in high-yield securities or so-called “junk” bonds, which are known to be more likely to fall into default than investment-grade bonds. Or it may buy into mortgage-backed securities, despite the fact that such securities have become harder to sell since the housing crisis of the prior decade. That opens the fund up to liquidity risk.
Like most investments, all bond mutual funds charge fees and expenses that are paid by investors. These costs can vary widely from fund to fund or fund class to fund class, but unconstrained bond funds are known for charging higher fees than other bond funds, with fees ranging from about 1 to 2 percent. Even small differences in expenses can make a big difference in your return over time. FINRA’s Fund Analyzer can help you compare how fees and other expenses can impact your return.
Unconstrained bond funds are distinct from two other bond fund categories: core funds and core-plus funds (also known as multi-sector funds). Core funds closely track certain bond indices such as performance of bond indices such as Bloomberg Barclays Capital U.S. Aggregate Bond Index, while core-plus funds attempt to mirror the features of certain bond indices but have more flexibility in terms of what investments they include.
Unconstrained bond funds, however, don’t attempt to replicate the allocations and performance of bond indices at all. Instead, they may track the London Interbank Offered Rate (LIBOR) or U.S. Treasury bills.
Since they’re not attempting to mirror any specific index, unconstrained bond funds often invest in a variety of debt instruments, including loans, foreign securities, mortgage-backed securities and credit derivatives such as credit default swaps. Their strategies may also include taking short positions, a maneuver that allows investors to profit when a particular investment declines in value. Such flexibility with respect to strategy is the reason that unconstrained bond funds are sometimes referred to as “go anywhere” funds.
Ultimately, as with any other investment, investors should do their homework before deciding to invest in an unconstrained bond fund. You can learn more about a specific unconstrained bond fund, and compare such funds and other mutual funds using FINRA’s Fund Analyzer.