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Are Nontraditional Bond Funds Living Up to Their Promise?

The answer depends on which promise you heard.

Eric Jacobson, 08/30/2012

The nontraditional bond category is dominated by funds that hope to produce absolute returns regardless of what's going on in the conventional bond market. By and large, that promise has been a response to fears over the potential for rising interest rates. Even though inflation has been tame over the last couple of years, Treasury bond yields are so low (in large part thanks to the actions of the United States Federal Reserve) that many investors believe that a large and sustained reversal of that trend is inevitable.

The good news for investors most fearful of rising yields is that this nascent category of funds has generally proven itself capable of putting up a good defense. That's not entirely surprising given that most funds in the category have tended to report durations (a measure of interest-rate sensitivity) close to zero, or in some cases even negative. Portfolio metrics and investment outcomes don't always match up, though, so it's reassuring that the group responded well during early August 2012, when Treasury bond yields spiked. The 10-year Treasury, for example, saw its yield go from 1.56% on Aug. 1 to 1.8% on Aug. 21, triggering a 2% loss inside of roughly three weeks. That's an arguably modest amount over a short period, but it's enough of a move upon which to judge how nontraditional bond funds have behaved. The results are encouraging. There are 43 distinct portfolios in the category, and the median fund in the group eked out a 0.4% gain at the same time the Treasury market was losing money. The largest funds in the group performed consistently with that average, though PIMCO Unconstrained Bond PUBAX did log a small loss.

There is clearly more to bonds than just interest-rate volatility, though, and it's fair to ask how funds of this type might fare when other ills befall the market. It would be ideal if we could backtrack to see how the group would have performed during the 2008 financial crisis, for example, but most portfolios in the category weren't around back then. The next best time period for scrutiny is therefore probably the third quarter of 2011. A variety of events, including scary news from the eurozone, sparked a sell-off among so-called risk assets and funds with meaningful credit and liquidity risks, in particular, were knocked around. The average high-yield bond fund lost 6.6% during the quarter, for example, while the average multisector bond fund--which typically holds allocations to lots of high-yield and non-U.S. debt--sank 2.8%. Things turned out just about the same in the nontraditional bond category: The average fund in the group fell 2.7% during 2011's third quarter, which helped push the category's median offering to a slight loss for the year. By contrast, falling Treasury yields were a big help to more conventional core offerings, such as those in the intermediate-term bond category, which averaged a 5.9% gain in 2011--outpacing the average nontraditional bond fund by more than 7 percentage points.

Taken together, those data suggest that while a majority of funds in this category have chosen to shy away from interest-rate risk, many have taken on credit risk instead. That's clearly true for the category's largest offerings: Although the $14.5 billion PIMCO Unconstrained Bond has recently been shorting non-U.S. developed markets, for example, the fund had roughly 36% in a combination of non-U.S. developed and emerging markets debt at the end of July 2011. And while JPMorgan Strategic Income Opportunities JSOAX has long reported a very short duration, a variety of shorts, and a lot of cash, it has carried plenty of long exposure to the high-yield market. The story is similar at Eaton Vance Global Macro Absolute Return EAGMX. That fund also boasts an ultrashort duration and uses a variety of other shorts, but it still boasts an eclectic mix of foreign bonds and currencies that spans the range from the Serbian dinar and Malaysian ringit to the debt of Argentina, Venezuela, and Poland.

There's no way of knowing whether the risks of rising interest rates or those surrounding credit and liquidity will be more pronounced in the future. That's especially true given that economic trends continue to zig and zag in what seems like a monthly dance. That alone argues, however, that investors should be cautious about how much and just what kind of risks their nontraditional bond funds are taking.

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

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