Nontraditional Bond 101

This year's Morningstar Barron's Alternative Investment Survey revealed that 18% of advisors now cite a poor bond outlook as motivation to invest in alternatives. Investors looking to protect their portfolios against rising interest rates have poured an astounding $43.3 billion into Morningstar's nontraditional bond category over the past year through July. That represents organic asset growth of a whopping 74.5%. But investors should tread cautiously--the category's constituents can vary widely. Although these funds can alleviate some rising-rate pain, those looking to for a bond-market antidote should understand the potential side effects of these funds.

The nontraditional bond category is a diverse bunch. Funds largely lie somewhere between two camps: interest-rate hedgers and credit speculators (and plenty are both). Each fund's allocation varies and some carry unique mandates, but all have significantly more flexibility than traditional bond funds. BlackRock Global Long/Short Credit (BGCAX), for example, falls purely in the credit camp and targets a duration of zero.  PIMCO Unconstrained Bond (PUBAX), on the other hand, can target duration between negative three and eight years. And then there are funds that act very much like high-yield bonds, such as  JPMorgan Strategic Income Opportunities (JSOAX), which has an unconstrained process, although its duration tends to be relatively low. While all the category's funds are relatively unconstrained, understanding their particular strategies can help investors understand how to use these funds in their portfolios.

Reading the Label
The nontraditional bond category offers many options, but choosing the wrong one might make the cure worse than the disease. To avoid that fate, focus first at the fund's strategy.  FPA New Income (FPNIX), for instance, focuses on principal protection and targets returns of CPI + 100 basis points, making it a good option for those concerned about the risk of inflation. The JPMorgan fund mentioned above seeks to outperform the T-bill by 2% to 8% per year without the volatility of a conventional bond fund. A fund with a near-zero duration target, such as  Driehaus Active Income , is a good choice for rising-rate environments because it's less susceptible to rising rates. In May 2013, for example, when the 10-year U.S. Treasury yield unexpectedly rose to 2.16% from 1.63%, more than half of the funds in the nontraditional bond category lost money, while this fund gained 0.74%. The PIMCO fund, however, can invest up to 40% in high-yield bonds and 50% in emerging markets (although it currently has only about 15% in emerging markets). That could lead to trouble during turbulent times. Investors, thus, shouldn't consider these funds a remedy for poor market conditions, as many tend to perform poorly when markets shun riskier assets.

Bad Medicine
Turning back to Driehaus Active Income, when high-yield bonds (as measured by the Bank of America AML US HY Master II Index) fell 6.3% in the third quarter of 2011, the fund lost 8.5%, while its typical peer declined 2.6%. The fund's showing looks especially poor, moreover, relative to the 3.8% gain the Barclays US Aggregate Bond Index enjoyed as investors shifted away from riskier assets. The JPMorgan fund was also hit hard in 2011 as Treasuries (which the fund owned very little of) rallied. During September of that year, its worst month, the fund lost 2.3% versus a loss of 0.90% for the category.

Investors thus shouldn't expect many of these funds to perform well in a "risk-off" environment. This year, the group fared better as credit risk was less of a concern. Amid fears of Fed tightening, the Barclays bond index fell 4.3% from late April through early July. Many nontraditional bond funds fared better--the JPMorgan Strategic Opportunities fund fell only 0.50%, for example, while the PIMCO fund fell 3.1%. Driehaus Active Income, which exhibits a very low duration, lost only 0.10%.

Although their correlations to the high-yield market vary, these funds have fared better this year in part because high yield has fared better. Because the high-yield market tends to move with equity prices, moreover, 2013's steadily rising stock market has also favored these funds. Typically, high correlations to high-yield bonds will also translate into elevated correlation to equities. (High-yield bonds tend to trade more similarly to equities than Treasuries.) The category exhibits a high correlation (0.86) to high-yield bonds and (0.60) to equities. The JPMorgan fund exhibits the highest correlation to high-yield bonds and actually has a negative correlation to the bond universe. The PIMCO fund, on the other hand, exhibits a weak correlation to high yield and the bond universe, while exhibiting almost no correlation to stocks.

Use Correlations to Guide Treatment
When selecting these funds, first start with a proper diagnosis, as the treatment depends on the aliment. Generally, nontraditional bond funds aren't a cure-all for rising rates, especially if credit spreads widen as well. But if investors incorporate correlations into their selection process, these funds can be excellent diversifiers.

Like any treatment, though, the remedy depends on the ailment. For instance, for a portfolio mostly exposed to equities, either the FPA or the PIMCO fund could be a good option, as those exhibit a correlation of negative 0.04 and positive 0.07 to the S&P 500, respectively. But for a portfolio mostly invested in fixed income, the BlackRock and JPMorgan funds might be a better choice; those exhibit a relatively low correlation with the bond universe. There is, however, a small caveat. Investors with a relatively high exposure to high-yield bonds might want to shy away from many offerings in this space. Perhaps in that case, one might risk overtreatment.