Sun, 8 Jun 2014
Fears of rising rates have driven large flows to the category, but investors must take care to not eliminate the 'insurance' that core fixed-income funds offer.
Christine Benz: I'm Christine Benz for Morningstar.com. The non-traditional-bond category has been gathering exceptionally strong asset flows over the past several years. Joining me to discuss the category and what to watch out for is Eric Jacobson. He is co-head of fixed-income manager research with Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: It's my pleasure, Christine. Thank you for having me.
Benz: Eric, first of all, this is a Morningstar term, "nontraditional bond." Let's talk about the types of funds that tend to cluster within this category. It's a pretty broad group, correct?
Jacobson: Yes. The umbrella itself is pretty broad. As the category has grown, I would say that the majority of assets are pretty homogenous, in terms of overall styles. They tend to skew toward the so-called unconstrained mandates or styles, but that's really a description of what funds can do rather than what's in the portfolios, which is a little unusual, certainly the way we do things at Morningstar. But this is unfortunately the best way to do it, is to gather them up this way.
But if you, once you get outside of those that are really defining themselves as unconstrained, you will find a handful that really are that but don't use the word. There are few that are really more suitably called true long-short funds that may be a little bit more like the concept you think of from the equity side, without any duration [a measure of interest-rate sensitivity]. A lot of them overlap with calling themselves absolute-return funds, as well, and ironically that is not exactly the best match in terms of being unconstrained and absolute return. But like I said, it's a pretty big umbrella, but they tend to be clustering toward that unconstrained style now.
Benz: One category we've had for a while is the multi-sector-bond category. People may be familiar with some of those funds, which may tend to invest in junk bonds, foreign currency-denominated debt, and so forth. How is this non-traditional-bond category different from that old multisector group?
Jacobson: I should say part of what's interesting about that comparison, which is an apt one, is that a lot of people are jumping from traditional core funds, much like for example, [funds that track] the Barclays Aggregate Bond Index or PIMCO Total Return, which is a little more broad than that, over to these unconstrained funds. And I think a lot of folks may not realize that in terms of the underlying assets, they do look a lot more like the multisector category that you just described in terms of the satellite nature of the assets that they go into, such as high-yield bonds, emerging markets, et cetera.
The big difference in general between those funds and the way that the nontraditional bond or unconstrained funds operate in large part is the fact that the nontraditional funds try to strip out a great deal of their interest-rate sensitivity and/or may much more actively manage it.
Normally duration is not a big lever that a multisector bond fund manager uses. They might try to do it around a benchmark or keep it relatively static, whereas an unconstrained fund can often even have an negative duration as well as the ability to go way, way out to plus 7 or 8 years which is tremendous amount of interest-rate sensitivity.
In a few cases, I would also point out, maybe more than a few, you're also dealing with funds that are much more tactical. Whereas the multi-sector-bond category, historically, has tried to strike some sort of balancing act between a few different sectors in order to have this diversification effect, but really tilting quite a bit toward high-yield historically, there are some funds in the unconstrained category that try to be much more tactical and try to ramp up their sector allocation in one area when it looks cheap and maybe even slash that within a month's time depending on what's going on in the market place.
Benz: We've seen this proliferation of these nontraditional funds, a lot of the unconstrained-type funds and others, as well as assets flowing into these funds. What do you think is driving this phenomenon where investors are buying these funds hand over fist? I was looking, it's exactly the second-biggest asset gathering category over the past year.
Jacobson: It's interesting because more than you think, there is probably a multifaceted answer to that question, and oddly enough, before anything else, I'd probably point to the fact that in many cases or as we sometimes say in this industry, these funds are often sold, not necessarily bought. What we mean by that is they are a favorite of people whose job it is to distribute funds like this because in part the story is usually pretty good, and frankly they make a lot of money for the fund companies because they charge more.
But from an investor perspective, I think the biggest impetus has been this ongoing and sort of recycling fear of rising interest rates in long-term bond yields. And you mix that, as well, with the fact that the credit exposures that these funds have, has actually been sort of ramping up their returns in certain periods.
They have a very nice-looking history right now which helps sell funds, too. But the big one certainly is the interest-rate fear. Even when the market rallies and funds like these don't do that well, the fact that yields fall further and further seems to be scaring people and pushing them into funds like this.
Benz: That's the story that has been easy for fund companies to sell, to say, "You're worried about rising rates; these funds could help cushion the blow."
Jacobson: Absolutely. And I think they're also playing off of this notion that we're at the end of a 30-year bond bull market that the only way rates can go is up, and sort of stoking the fear that not only are they going to go up but they're going to go up a lot and that that's going to be our life for the next 10 years. That has really helped them divert money, I would say, out of core bond funds and into funds like this because they sell it based on the expectation that managers are either going to keep their interest-rate sensitivity relatively low and/or tactically manage it expertly.
Benz: When you look at performance of these funds, Eric, and I know it's early days for a lot of them, what does the return profile look like versus, say, the core intermediate-term bond funds that investors usually used as core holdings? And then what does the volatility look like with these funds relative to say the Barclays Aggregate Bond Index or some sort of core intermediate-term bond fund?
Jacobson: Right. The history, again because of what you said about them being relatively small in number and don't have much of a long history, but still they're very dependent on time period. And what I mean by that is we've had a handful of events in, say, the last five years--and you can even go back to the financial crisis but a lot of these funds weren't around yet--and you can look at different periods during the last few years to see how they did during those periods. And it helps explain why for example the nontraditional category beat the intermediate-term bond category as an example, home to the core funds, over a five-year period. It did not perform as well over a three-year period, but it did better during 2013.
I know that's sort of a litany of things, but my point is just that you've had different environments. With 2011, we had a really bad period for credit and that hurt the nontraditional funds and helped funds with more interest-rate sensitivity. Then 2013 hurt the traditional funds a lot more because they had the interest-rate sensitivity, and this was the time for nontraditional bonds to shine because of their relatively low and, in a few cases, even zero or negative durations.
Benz: You've touched on this in a few different ways. It sounds like duration risk isn't typically a risk for these funds or oftentimes is not, but that credit risk could be a bigger concern. And I am guessing you will say investors ought to keep it on their radar?
Jacobson: Absolutely. Normally we're careful about translating credit risk to volatility because it really depends on time periods like I just said, but you can look at time periods like the ones I described and you can see just what impact those kind of events have had on nontraditional funds versus traditional funds. If you look, for example, at the period of 2009 to 2011--I picked that because it's kind of long enough to actually get some useful statistics--you'll see that the volatility in the nontraditional funds was definitely higher than it was for the core intermediate-term bond funds. Then if you look at it from the period of 2012 to early 2014, which includes that rough summer 2013 interest-rate spike or bond-yield spike, the volatility of the nontraditional funds was lower. And so that really tells you that for the most part, the category is leaning much work toward credit than traditional funds, and at the same time, it's doing what it promised in terms of taking less interest-rate risk.
Benz: Taking a step back, when you think about this category and what role these funds might play in investors' portfolios, do think they have a role, and for whom?
Jacobson: It's a very, very tricky question because I do think that there are investors who, no matter what, really want to get the interest-rate volatility or the risk out of their portfolios, but they still want to have bond exposure. The big caveat there though is that this is not the equivalent of an intermediate-term bond fund generally speaking without interest-rate risk. It much more looks like a much riskier, and I don't mean off the cliff, but comparatively riskier multisector fund without the interest-rate risk.
That's an issue, and it has a lot of implications for the question: Does that really fit into an investors' portfolio the way that a core fund does? And one of the reasons that it's such a big issue in my opinion is that the core fund space, where everybody is worried about rising rates, also provides what I think of is as some insurance.
What I mean by that is those core funds have interest-rate sensitivity, but when there are time periods of market distress like we had in the third quarter 2011 and we had in spades in 2008, the only thing that tends to do well are Treasuries and interest-rate duration as we say. And that turns out to be a very, very important ballast, even if it's a relatively modest portion of your portfolio when everything else is selling off. And by the way all that credit stuff that I am referring to as you'd imagine with those time periods coincides with periods that equities are selling off.
So, if you have a very equity-heavy portfolio and you strip out all the interest-rate sensitivity of your bond portfolio, you've got almost for sure very highly correlated assets at that point across the board, and you've given up on your insurance. And I think that's pretty sort of a risky thing for people to do.
Benz: Eric, thank you so much for being here to share your insights.
Jacobson: My pleasure, Christine. Great to be with you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.