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A Flexible Approach to Fixed Income

More flexible mandates for bond funds may offer more investment options, but it also may introduce complications, managers say.

Morningstar, 04/28/2017

This analyst blog is part of our coverage of the 2017 Morningstar Investment Conference. 

The low bond yields of the past few years have left investors questioning what will happen with their core bond portfolios when yields rise. This anxiety, in turn, has fueled discussion around embracing bond funds with more flexible mandates. This flexibility can take a variety of forms--wide-ranging duration, a broader sector menu, equitylike exposures through convertible bonds and bank loans--and while it expands the menu of investment options for a bond fund to generate value, it may also introduce complications.

Brian Kennedy, a comanager on the Loomis Sayles Bond LSBRX, which is considered one of the original absolute return bond fund strategies, and Bryan Whalen, a generalist portfolio manager at TCW and part of the team that manages Metwest Total Return MWTRX, sat down with Morningstar's Miriam Sjoblom to discuss their own views on the merits and risks of flexible bond investing at the Morningstar Investment Conference on Thursday.

From the opening, the topic of rising interest rates was tossed into the discussion ring. Is this bad for bond funds generally? Both managers agreed that a rising rate environment wasn't strictly bad for bonds. In particular, a flexible portfolio gives you the opportunity to buy into idiosyncratic risk. Kennedy emphasized that, from a traditional bond investor's standpoint, value has been taken away by the central banks. Subsequently, investors must climb down the credit spectrum and into a host of areas--such as high-yield and emerging-markets debt--to find yield. 

What's important for investors to remain aware of is risk tolerance. What is the time horizon? How much volatility are you willing to take in this market? For Kennedy, it's about collecting income over time, and remaining patient over a market cycle.

"An unconstrained fund shouldn't replace a traditional bond fund but should instead complement a traditional one," said Whalen. "Unconstrained doesn't mean always taking the maximum amount of risk. From our perspective, it means dialing up and dialing down credit exposure depending on where you are at in the credit cycle."

Kennedy noted that high-yield issuance has behaved better than it could have recently, while Whalen said liquidity is the greatest systematic risk. Both managers exercise flexibility in their portfolios, but each has a different emphasis. 

For Kennedy, it's identifying when an industry is in a downturn, and if there is a fundamental credit opinion that the situation will improve in two to three years, along with preferences for convexity and low callability, executing on that view. For Whalen, with his securitized background, it is about remaining vigilant to a range of possibilities. Liquidity is of the utmost importance, and newer structures--such as credit-risk transfer deals, single family rentals, and peer-to-peer lending--which haven't been stress-tested through a crisis, require skeptically-driven analysis.

The managers shared a perspective on bond investing that isn't exclusive to unconstrained strategies. Ultimately, there are many ways to manage bond funds but acutely understanding the risks involved and consciously employing or limiting those risks is critical to successful fixed-income investing.


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