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By Christine Benz and Eric Jacobson | 05-29-2014 03:00 PM

What's So Attractive About Nontraditional Bond Funds?

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 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.

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