Beware Unconstrained Bond Fund Strategies

December 26, 2014

Nontraditional bond funds have had a 90 percent correlation to the Barclays US High Yield Corporate Bond Index. They have a 65 percent correlation to stocks. They are almost completely uncorrelated to the broad U.S. bond market, as represented by the Barclays Aggregate Bond Index.

When investors move from a broad bond-market vehicle such as the iShares Core U.S. Aggregate Bond ETF (AGG | A-98) to an unconstrained or absolute-return bond fund, they are trading apples for oranges. If they are looking to hedge their bond risk, then nontraditional bond funds do a good job, just as equities and high-yield bonds do.

However, if they are using clever bond alternatives to replace their core fixed income in blended stock/bond portfolios, they are greatly reducing the diversification of the overall portfolio.

They should expect their portfolios to pitch up and down in conjunction with the corporate stock and bond markets. And, crucially, if the stock market drops, they shouldn't expect their bond holdings to save them.

The Cost Of Chasing Yield

Nontraditional products are also expensive.

If we look at the top five funds in the Morningstar category by assets, the average expense ratio of the least expensive share class (institutional shares or load-waived A shares) is 0.80 percent, or $80 for each $10,000 invested.

For comparison, the core bond funds offered by the same five managers have an average expense ratio of 0.63 percent. Meanwhile, the high-yield ETF universe, including the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-68) and the SPDR Barclays High Yield Bond ETF ( JNK | B-68), are 50 and 40 basis points, respectively. Those two funds and a number of others, have average expense ratios of 0.54 percent. That 24 basis-point difference is big in a low-yield world.

Admittedly, holding high-quality fixed income represents a different kind of cost—an opportunity cost—especially when interest rates are low and during equity bull markets. The opportunity cost is measured in the form of foregone returns.

However, we think of temporary, low returns much as we think about a premium on an insurance policy that pays off when equity markets sell off and high-quality fixed income should outperform. Many unconstrained and equitylike bond choices simply don't stand up during equity-market weakness.

So, why has the nontraditional category ballooned? I suspect it comes down to two reasons: marketing, and what we call the party effect.

Marketing of income alternatives by the mutual fund complex, which includes horror-show hypotheticals about spiking interest rates, has ensured investors are well aware of what fixed-income worst-case scenarios look like—regardless of how unlikely those scenarios may be. To be blunt, we think fears of rising rates are largely overblown.

I talked about that in a recent column titled "5 Reasons Your Duration May Be Too Short."

The party effect, also known as "recency bias," is where investors use recent historical performance to extrapolate views on longer-term future performance. This practice is especially prevalent but dangerous after multiple years of markets that move in a single direction. To that point, the last I checked, we are entering the seventh year of our equity bull market.

Investors may do well to use nontraditional fixed income to diversify their core fixed-income holdings, but probably not their high-yield or equity holdings. 

Alternatively, they could simply use the time-tested combination of equities for capital appreciation, high yield for income and core bonds for diversification and volatility reduction. Is it sexy? Nope. Is it practical? You bet it is.


At the time this article was written, the author's firm owned shares of HYG on behalf of clients.


Sage, an independent investment management firm, serves institutional and private clients with traditional fixed-income asset management and global tactical ETF strategies. Sage began using ETFs in 1998, and today offers a range of tactical all-ETF solutions, including income-focused and target-risk global allocation strategies. Contact Sage at 512-327-3330



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