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How to Evaluate a Nontraditional Bond Fund

Don't rely on a benchmark.

Nadia Papagiannis, CFA, 08/30/2012

Morningstar created the nontraditional bond category in October 2011 in response to a proliferation of bond funds that couldn't be fully described by Morningstar's fixed-income style box; that is, these funds can fully hedge or take bets against credit or duration risk. The first wave of these products were called "unconstrained" bond funds and had the ability to take net short positions in Treasuries in the event of rising interest rates. As investors' fears of rising interest rates have subsided, the focus has now turned toward funds with new sources of generating alpha, particularly by taking both long and short credit bets. But despite any similarities these nontraditional bond funds may share, their differences are vast enough to make comparisons difficult. The strategies range from hedged emerging-markets local debt to long/short U.S. Treasuries, and the returns are equally disparate. In 2011, the average nontraditional bond fund lost 1.3%, yet the best fund made well over 6%, and the worst fund lost more than 9%. So how does one go about evaluating funds in such a heterogeneous category? Here are some helpful tips. 

Don't Rely on the Benchmark
Typically, when an investor wants to know what exactly a mutual fund invests in, he or she must simply look up the stated benchmark in the prospectus. For the 43 nontraditional bond category constituents (as of Aug. 29), the benchmark is either missing (for 17 of 43 funds) or it is a cash equivalent (three-month Libor or Treasuries, for example, for 22 of 43). Not knowing the benchmark makes performance difficult to assess, and comparing performance to a cashlike benchmark, which implies the fund is not taking on any market risk, can make performance appear too good to be true. Therefore, it's important to select an appropriate benchmark for performance analysis.

The first step to selecting a good benchmark is to determine what the fund actually invests in. For example, JPMorgan Strategic Income Opportunities JSOAX can invest in anything according to its prospectus (as can many of the funds in this category), but its holdings reveal that it invests primarily in high-yield U.S. corporate bonds (44% as of July 31), with a smattering of mortgage-backed securities, asset-backed securities, and bank loans. It's not surprising, then, that the fund's correlation is highest to the Bank of America/ Merril Lynch High Yield Master II Index (as determined by Morningstar's "best fit index" data point). The high correlation (0.94 using the 36 months ending July 31) indicates that the high-yield index is a more appropriate performance benchmark than the one stated in the prospectus.

Mind Your Market Risk
Once the benchmark index is selected, the next step is to look at alpha relative to that index. Because nontraditional bond funds can invest in cash or take short positions, both of which will reduce the funds' net credit or interest rate exposures, it's important to look at alpha, which takes the lower market exposure into account. Over the last three years, JPMorgan Strategic Income Opportunities has exhibited a negative alpha relative to the aforementioned high-yield index--meaning, it has not added any value relative to its exposure to the high-yield market. It has also underperformed the high-yield bond category average by a wide margin since its October 2008 inception (through Aug. 28), but this is not necessarily an indication of good or bad performance. Investors should expect hedged credit strategies to underperform the market during market rallies, and bonds have largely rallied since the fund's inception. Going forward, however, the fund may have a leg up relative to long-only high-yield funds, given its ability to go to cash or to hedge against interest rate risk.

How Does It Hedge?
When it comes to fixed income, hedging is not always easy. Shorting fixed income is expensive, especially for higher-yield issues, because the borrower must pay the coupon in addition to any other borrowing costs. Buying credit default swaps is a cheaper option, but not all credit default swaps are liquid (for example, index credit default swaps are more liquid than single name protection). Furthermore, certain types of debt, such as municipal bonds, cannot be directly shorted. Therefore, imperfect hedges, such as shorting corporate bonds of similar credit risk or shorting Treasuries of similar durations, must do for funds such as the high-yield municipal bond fund Forward Credit Analysis Long/Short FLSIX. Shorting Treasuries can be treacherous, especially in the current risk-on, risk-off macroeconomic environment, because a quick flight to safety can cause Treasuries to jump. In fact, many of the largest funds in the nontraditional bond category got into trouble shorting Treasuries in 2011, when the Barclays US Treasury Index rose 9.8%.

Portfolio Placement
As with other alternative strategies, nontraditional bond funds should not be looked at in isolation, but rather as diversification tools for traditional portfolios. To the extent that a nontraditional bond fund exhibits a relatively low correlation to one's existing bond holdings, and to the extent one believes the fund will produce positive returns over time, an allocation to a nontraditional bond fund should improve the portfolio's overall risk-adjusted return. All of the 16 nontraditional bond funds with 36 months of returns (through July 31) have exhibited low or negative correlations to the Barclays US Aggregate Bond Index, the index typically used to represent the 40% of a traditional 60/40 portfolio. PIMCO Unconstrained PUBAX registered the highest correlation, at 0.40.

To Categorize or Not to Categorize
Although funds in the nontraditional bond category are more difficult to evaluate than funds in other Morningstar categories, the category is a good starting point for investors to narrow down their bond diversification options. Armed with a few extra data points, investors can make a well-informed allocation decision.

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Nadia Papagiannis is an analyst with Morningstar.
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