Beware Unconstrained Bond Fund Strategies

December 26, 2014

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Anthony Parish, vice president of Research & Portfolio Strategy at Austin, Texas-based Sage Advisory Services.

Sure, I get it. Yields are low. Income is scarce. So naturally investors are looking beyond traditional fixed income to meet their needs. The mutual fund industry, always looking to capture share-of-wallet, has flooded the market with income-alternative products.

Here's the problem: With some possible exceptions, these products are terrible substitutes for traditional fixed income.

The Role Of Fixed Income

It's easy to forget, but the main reason most investors own fixed income in portfolios, aside from the income itself, is to provide diversification versus stocks and relatively predictable returns. When combined with equities and other asset classes, high-quality fixed income improves portfolio risk-adjusted returns.

Investment-grade bonds bring a combination of low volatility and negative correlations relative to stocks. That's their role on the team.

So, when investors reallocate from traditional fixed income to nontraditional fixed income, what kind of experience should they expect?

Welcome To Nontraditional Bonds

Let's look at the Morningstar Nontraditional Bond category for answers. Over the past five years, the category has nearly quadrupled, from 24 funds at the end of 2009 to 92 at the end of 2014. Worth noting is that although Morningstar only introduced the Nontraditional Bond category in 2011, it provides retroactive classification for investors who want to analyze the fund peer group prior to that time.

In any case, it is an incredibly diverse group, including unconstrained, absolute return, strategic income, long/short, opportunistic and other types of funds.

You would think such a diverse group would deliver a diversified return stream, helping to smooth out volatility, right?

Think again.

Surprising Findings

When we looked at monthly total returns of the category relative to other categories, we found that nontraditional bond funds are basically high-yield corporate bond funds in disguise. 



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