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Nontraditional Bond Funds: Are They?

Not so much, it appears.

John Rekenthaler, 09/19/2013

A few years back, the mutual fund industry began to market a new breed of bond mutual fund. Carrying various labels, among them unconstrained, flexible, opportunistic, tactical, long/short, and absolute return, these funds promised to reduce or even eliminate their exposure to changes in interest rates. That way, they could thrive in all markets. Several wrote into their prospectuses the ability to adopt a negative duration, so their portfolios could profit from rising rates, even as other bond funds lost money.

Unusually for the fund industry, this new breed--which Morningstar categorizes as nontraditional bond funds--looked forward rather than behind. Generally, new mutual funds are launched to win the last investment battle; for example, tactical asset allocation and managed-futures funds that would have thrived in 2008, hit the marketplace in 2009 and 2010. However, nontraditional bond funds were built for now. They were built not to squeeze maximum profits from the big bond bull market, but to shine when interest rates turned and other bond funds struggled--as in this summer.

They did not fully deliver on the promise. Nontraditional bond funds started off with a flourish, shedding just 0.30% on average as interest rates began to head up in May, as opposed to a 2.18% decline for PIMCO Total Return PTTAX and a 2.43% loss for Vanguard Intermediate-Term Bond Index VBIIX. However, they were less impressive in June, as the category skidded to a 1.63% drop. That conventional bond funds fell about 1 percentage point further offered only modest consolation. Similarly, when PIMCO's fund fell by 1.11% and Vanguard's by 1.25% in August, the nontraditional category came along for half the ride, losing 0.52% on the month.

Unfortunately, if any of the nonconventional bond funds followed through on their prospectuses by adopting a negative duration, that didn’t show up in the numbers. In June, the worst month for high-quality bonds in five years, and thus a prime opportunity to make money through a negative duration, not a single nonconventional bond fund turned a profit. BTS Tactical Fixed Income BTFAX came closest with a drop of just 0.10%, but as the fund fell by more than 1% in both May and August it offered little joy. The best were Putnam’s Absolute Return funds, as the 100 Series slipped by 0.20% in both June and July but had no other losing months, and the 300 Series lost 0.46% in June but otherwise landed in the black.

Putnam’s smooth performance, however, comes at the cost of longer-term returns. Over the trailing three years through August, the 100 Series has made but 0.86% annualized and the 300 Series 1.94%. In contrast, the PIMCO and Vanguard funds are each over 3%. The PIMCO and Vanguard funds are also each moderately ahead of the nontraditional bond fund average for that time period, by about half a percentage point per year.

There’s no need to kick around the category. Finishing only modestly behind two excellent bond funds for the past three years isn’t bad, particularly as most nonconventional bond funds have relatively low volatility. Also, while none of the funds caught the recent bear market just right, several made very good money during the bond bull market and have posted excellent three-year gains. There are plenty of reasons to like this category’s better entrants.

But for dodging interest-rate rises? Not so much.

The Retirement Crisis Redux
Here a crisis, there a crisis, everywhere a crisis crisis. Yesterday, Pensions & Investments suggested "ways U.S. could help solve its retirement crisis.” Yahoo Finance ran an article about why my retirement “won’t be like your parents’” and what I “can do about it.”

is vice president of research for Morningstar.

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