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By Jason Stipp | 03-23-2011 07:59 AM

Is a Free-Ranging Bond Fund Right for You?

Morningstar's Eric Jacobson discusses the history and re-emergence of flexible bond funds, sizes up the offerings today, and offers tips on incorporating them into a portfolio.

Jason Stipp: I am Jason Stipp for Morningstar.

If you haven't heard of an "unconstrained bond fund," you probably will soon--as this set of funds is increasingly gaining investors' attention.

Here to talk a little bit about what these funds do and how you can compare them is Morningstar's Eric Jacobson. He is director of fixed-income research.

Thanks for joining me, Eric.

Eric Jacobson: Great. Thanks for having me.

Stipp: So the idea behind an unconstrained bond fund isn't entirely new. This is something that we've actually seen before. Can you talk a little bit about the history of this type of fund and what exactly it does?

Jacobson: Sure. Well, you are not likely to go back in history and find any funds with that name, but the fact that these kinds of strategies have been used before is really the lynchpin, in that if you go back and look at regular "plain-vanilla" bond funds, if you will, though they weren't really all that plain-vanilla, back in say, the 1980s in particular, you'd find that managers had a lot of flexibility to do a lot of different things. Maybe not so much in terms of the sectors that they would invest in, but certainly in terms of their interest rate sensitivity. And not all that unlike what people may remember about stock investing from that period, people tended to think, "Well, I'll just turn the money over to my bond manager and he or she should be able to predict the level of interest rates and things like that," and they gave them a lot of freedom.

Stipp: So, flexibility is really the key here, then, in the sense of "unconstrained." So, the managers of these funds are they truly go-anywhere managers? Do they have the latitude to really go out and bargain-hunt and just invest in whatever corner of the fixed-income world they see opportunity?

Jacobson: Well, you know this is a developing category, if you will, in the sense that it hasn't really gelled into what I would think of as a permanent state, but the core group of funds that are starting to stake out this territory really have gotten a lot of latitude.

So, for example, there is one really big one from PIMCO, called PIMCO Unconstrained Bond, and they have an analog under the Harbor brand as well that's no-load, and that fund can go negative three years in terms of its duration, or interest rate sensitivity, and as long as positive eight years.

So, that is really a wide range, and the sector palette, if you will, that's available to that fund is extremely broad as well. I believe it can have somewhere up to maybe 50% in high yield, and emerging markets and thing like that can go into the mid-30s I believe. So, there is a lot of freedom and flexibility.

Stipp: So, you mentioned Eric that we did see back in the '80s that fixed-income managers had a bit more flexibility. I am assuming that this style of investing then went out of favor for a while, and now it's come back as we are seeing some of these unconstrained bond funds come up. What happened to them in the intermediate time, and then why have they come back into popularity now?

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