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The New Non-Traditional-Bond Category

More a triumph of marketing than of investment acumen.

Eric Jacobson, 01/19/2012

Still in their early years, non-traditional-bond funds haven't impressed.

Morningstar launched the non-traditional-bond category in November 2011, partly in response to an explosion of new bond funds over the past few years. In fact, there are only seven funds in this category that even existed prior to 2008, and a couple of those changed their mandates in recent years to better feed investor appetites.

So, what is a non-traditional-bond fund? Broadly speaking, the category is meant as a home for funds that pursue strategies that diverge in some way from conventional practice in the bond-fund universe. In practice, most of these newish offerings--there are now 37 distinct funds in the group--have been designed to try to protect investors from the boogeyman of rising bond yields, while attempting to generate positive returns without the typical downside volatility that comes along with taking market risks.

The two most prominent flavors of funds in this new category typically describe themselves as pursuing either unconstrained or absolute return strategies. Funds in the unconstrained camp typically highlight their broad mandates to invest heavily across a wide spectrum of sectors and their ability to take their durations (a measure of interest-rate sensitivity) down to zero, or even negative. Absolute-return-focused funds usually emphasize their intent to generate positive returns and avoid losses, rain or shine.

Those promises were well received by investors early on. What was a relatively tiny $3 billion category in January 2009 exploded for most of the three years that followed, nearly touching the $60 billion mark in July 2011. PIMCO Unconstrained Bond PFIUX and JPMorgan Strategic Income Opportunities JSOAX have been the strongest beneficiaries of that growth, each crossing the $10 billion mark in the second half of 2010, leaving most of the field in their dust. The performance of those two offerings has been less impressive than their sales numbers, with both trailing the (admittedly small) group average over the past three years, though the JPMorgan fund has at least beaten the Barclays Capital U.S. Aggregate Bond Index over that stretch.

Thus far in their short histories, most funds across the category have acted in fairly homogenous fashion. Some take on a bit more or less risk than others do, but nearly all of them have kept their durations very short while taking on some measure of credit exposure in order to try to generate gains. That has proved a very tall order over the past year, though, as a strong Treasury-bond rally--and the falling bond yields that came with it--paved the path to riches in 2011, while the riskiest sectors produced anemic or negative returns. Not a single fund in the category managed to beat the Barclays Aggregate last year, which ended on a 7.8% gain. A couple came close, while a small handful otherwise managed to eke out positive returns. On average, the distinct portfolios in this group lost around 1% for the year.

That would appear to be a factor behind the category's recent contraction. Although not yet an apparent crisis, assets did begin to flee the group just as things got dicey last summer for riskier sectors and the Treasury market surged. Morningstar estimates that investors have pulled roughly $6.2 billion from the group since July of last year, reversing a robust trend in flows that had been consistently positive since late 2008.

In fact, it's not yet clear that this nascent group is deserving of all the attention it has garnered. Heading off what some see as the inevitability of rising bond yields may at some point prove valuable, but those who shifted money into this category from their more conventional bond portfolios coming into 2011, in particular, have likely been disappointed with the outcome thus far.

For anyone considering this group, it is important to understand the roots of that disappointment. While funds in this category are generally marketed on the merits of their flexibility and promise of absolute returns, as a group they've been more about dumping interest-rate risk in exchange for some other risk, whether it's a focus on high-yield, emerging markets, or other so-called "spread" or "risk" sectors. In fact, only two of the 13 funds with a three-year record have proved to be less volatile than the Barclays Aggregate. Of the funds that have reported their credit-quality breakdowns to Morningstar, three fourths have at least 25% exposure to junk bonds.

That worked quite well in 2009 for the handful of funds that were able to take advantage of that year's postcrisis rebound, but it clearly provided less balance in 2011. And while such a stance may prove worthwhile if we do see a sustained rise in bond market yields, it could prove problematic should we endure a more persistent bear market for risky assets.

Eric Jacobson is Morningstar's director of fixed-income research and an editorial director for mutual fund content.
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