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Is a Free-Ranging Bond Fund Right for You?

Jason Stipp

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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Jacobson: Right. So, if you will recall, back in the mid-'90s really actually 1994 was sort of the turning point at which we had been on a long stretch of falling interest rates, and they started to rise very, very sharply in 1994, and a lot of funds that had been taking positions that really required interest rates to stay low got absolutely devastated. There were lots of repercussions all around. Even managers who had sort of advertised themselves as all-weather kind of managers really weren't.

It really changed the landscape of the industry, including at some really big firms like Fidelity, for example, and a number of firms at that point began really looking at how they managed interest rate sensitivity across an entire swath of their fund lineup.

Fidelity, I cite as the biggest one, because they changed everything, and at that time they linked all their funds' interest rate sensitivities to benchmarks, and they weren't the first and they weren't the last; there were others before them, that were kind of institutional in that way and then almost everybody followed within the next few years after that.

Stipp: So, I am assuming that today they are coming back into favor; I can guess why this might be an attractive style right now, given that there are a lot of clouds out there in the fixed-income environment looking forward. But is it just that folks are worried about interest rates and their fixed-income holdings that this style has come back into popularity now?

Jacobson: I think it's pretty clear that the biggest motivator right now is that there has been a lot of fear in the marketplace for the last couple of years about rising interest rates, and it's just getting more and more acute as we go along. If you look at this group of funds, which, as I said, is still sort of a developing group and we are looking at what the parameters are of it, but it has grown tremendously.

And it's very, very clear when you talk to planners and investors who are considering them or buying them that interest rates going up is the chief fear, but rolled all into that is, again, as I said, this idea of being able to go into all different kinds of sectors and markets in order to pick up extra income and beat the market, if you will.

Stipp: So, you mentioned Eric that back in the '90s funds that were investing in a somewhat similar style really got slammed.

Is there a concern that this unconstrained bond strategy could face a similar problem if we see interest rates move in directions that were unanticipated?

Jacobson: Well, I think that is one of the dangers, and you know the danger overall is that, not every manger that does this is necessarily going to be an expert interest-rate caller, if you will, or have all the right decision-making prowess to be in the right sectors.

So, by and large, interestingly enough, if you look at the returns for the last couple of years on some these funds that have grown quite large, they are not all that impressive, because the funds have been very conservative, because that's what people are looking for right now in terms of interest rate sensitivity.

But when you consider the breadth of what they can do, and what they are saying they will do over the full market cycle, there is potentially a lot of risk in this category, because you are marrying a tremendous amount of freedom with some potentially very high-risk sectors, and even just basic decisions about interest rates.

Stipp: So, given that, Eric, how do you begin to perform due diligence if you're looking at these funds? If you find the strategy appealing, the flexibility appealing, how can I make sure that I'm giving myself the best shot at success, if I'm going to invest in an unconstrained bond fund?

Jacobson: Well the most basic thing that you want to do, and I think a lot of people probably haven't done this in a long time, but if you're doing it on your own and really digging in, you're going to want to look in the prospectus, at least as a starting point, to see if we can find out what kinds of parameters the fund is dealing with in terms of its interest rate sensitivity or what kind of sector exposure it can take on.

Now, as I said, a lot of these are written very broadly. So, you may just find that the few funds that you're interested in or are looking at are very, very broad. And then, if that's the case, you got to decide, am I comfortable with that level of risk-taking?

And then the next step that I would encourage is to really try and get some sense of who the management team is that's running the fund, and try to get really comfortable with them. I realize that's a very hard thing to do as an individual investor. Of course, that's what part of what we're here for. But certainly take the fund companies up on all the information that a lot of them are starting to push forward. A number of these fund firms, I think, partly because of the fact that the strategy is renewing itself with a relatively new scope, they are doing a lot more public relations, if you will. They are putting a lot more information on their websites, more interviews with managers. So, there is a little bit more that you can probably get out of them then you might have been able to get a few years ago.

Stipp: So it sounds like this group of funds still has a little bit to prove given that it's still emerging. But do you have any management teams on your radar that you think have a good shot at success here?

Jacobson: That's a great way of putting it, because I don't think we're at the point yet where we're really comfortable making a strong recommendation on any of them, but we certainly have identified a few where we know the management teams. We've got a few others where we're getting to know them better, and we're starting to sort of see the outlines of funds that we think we might want to start recommending down the line if it seems like they wind up doing a good job.

The first one that comes to mind, perhaps obviously, is PIMCO Unconstrained, which we've mentioned before in other videos and in columns and so forth. The reason for that is not only that the lead manager, Chris Dialynas, is a long-tenured veteran at PIMCO, although a lot of people don't know him because he's been running institutional money, but he is a member of the investment committee, and he really, really relies on a lot of the sensibilities of his colleagues: Bill Gross, Mohamed El-Erian, and others, very senior guys at PIMCO, who have a lot of really, really strong macroeconomic moorings.

One of the other things that I think is very, very important here, aside from just that issue, which is especially linked to interest rate sensitivity and macroeconomic calls, are the underlying teams that are going to be running the sleeves, if you will, of different sectors that he may choose to go into. Whether it's high-yield, emerging markets, non-dollar sovereigns, and things like that, you want to really have a strong sense that they have really good capabilities underneath there.

PIMCO is a kind of place where we feel very comfortable with that. There are only a handful of shops that can really even come close to that. So, if you start going down the ladder and finding others, you really are putting a ton of trust in a smaller team and perhaps even in an individual manager.

Stipp: Last question for you, Eric, given that these funds potentially have a wide-ranging stomping ground, how do you think about, from a portfolio-management perspective, fitting a fund like this into your holdings? Maybe they are holding some kind of bonds this month but six months from now, their portfolio maybe could look completely different. How do I incorporate that into my existing asset allocation?

Jacobson: How to incorporate an unconstrained fund into a portfolio is one of the most interesting questions you can ask, really, because I don't think anybody knows for absolute certain, yet. Really, though, you've got to think of it at the moment, I think, as sort of an add-on to your portfolio, especially until you get some strong sense, if you can, of what kind of universe the fund is most likely to occupy most of the time.

But by and large I would say you probably want to start by filling it in on the margins, not necessarily replacing it as your core fund, although I think a lot of people are doing that and want to do that because they are so fearful of rising interest rates. It's hard to tell someone not to, because in theory, if we see a very, very sharp spike, core bond funds could lose a good deal of money in a very short period of time. But over the longer term, you probably want to have that little bit more predictable portfolio, and if you put quote-unquote all your eggs in one basket by dumping your core funds and buying an unconstrained fund, the predictability of your portfolio is going to be a lot lower than it might otherwise be.

Stipp: Well, Eric, thanks for the context on this very interesting, emerging group of funds. I'm sure you'll be keeping a close eye on them, and we'll look forward to checking it with you on them in the future. Thanks for calling in today.

Jacobson: Great. Glad to be with you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.