3 New Non-Traditional-Bond Funds Leap Into the Fray

The first five months of 2014 have reminded investors once again that interest rates have a way of confounding the experts. Despite a rousing chorus predicting that interest rates would rise this year, they've done the exact opposite so far. The yield on the 10-year Treasury has fallen from 3.00% at the start of the year to 2.47% in mid-May, its lowest level since October 2013.

That hasn't stopped mutual fund companies from continuing to roll out new products designed to better navigate a rising interest-rate environment than traditional long-only bond funds. Companies have launched 10 new non-traditional-bond funds through the end of May, on pace to surpass the 20 such funds launched in 2013. Newcomers include Janus and DoubleLine, which are taking their first step into strategies that allow for a negative duration. That tool can, if used correctly, mitigate the risk of rising interest rates, which are inversely correlated to bond prices. 

Indeed, interest rates have been edging back upward since dipping below 2.5%; the yield on the 10-year Treasury was back around 2.6% as of early June. But they would have to move a lot higher and a lot faster to fulfill the doom and gloom prophecy for plain-vanilla bond funds, which have little leeway to manage duration risk, that has caused so much anxiety among investors.

The lower rates, however, may be further stoking that anxiety. The lower that rates go, the more rising interest rates pose a threat, since the lower yields would provide less of a cushion for the falling bond price if rates eventually spike. Non-traditional-bond funds have received $19 billion of net inflows year to date through the end of May and $81 billion during the past 24 months.

The category covers a wide range of funds, which variously go by names such as "unconstrained," "strategic income," "opportunistic," and "flexible." The one thing they tend to have in common is delivering on the promise of less duration risk (the category norm is an average effective duration of one year, compared with a category average of 4.9 years for intermediate-term bond funds). To compensate for the lower duration, many managers have turned to another driver of bond returns, credit risk. To illustrate, the average non-traditional-bond fund has a 0.88 correlation to the high-yield bond category since 2011, whereas intermediate-term bond funds have just a 0.14 correlation.

Maiden Voyages
The newly launched Janus Unconstrained Bond (JUCIX) and DoubleLine Flexible Income (DFLEX) don't seem to offer much of a different take on the space, as both have wide-ranging mandates that allow for negative duration and the ability to invest across the fixed-income spectrum. What could set them apart, however, is their notable management teams.

Gibson Smith and Darrell Watters, comanagers of Silver-rated  Janus Flexible Bond (JFLEX) and Bronze-rated  Janus High-Yield (JAHYX), have the reins at Janus Unconstrained Bond. The duo may be the best kept secret at Janus. Janus Flexible Bond's 6.13% 10-year annualized returns through the end of May beat 90% of peers in the intermediate-term bond category, including  PIMCO Total Return (PTTAX), thanks primarily to management's expertise in fundamental credit research, a skill that should prove beneficial in a non-traditional-bond fund.

DoubleLine Flexible Income is managed by former Morningstar Fixed-Income Manager of the Decade nominee Jeffrey Gundlach. Gundlach has been perhaps the most vocal contrarian when it comes to interest rates (on a January conference call with  DoubleLine Total Return (DBLTX) shareholders, he correctly predicted that interest rates would fall to 2.5% in the near term), so this fund comes as a little bit of a surprise. Still, the strategy's framework falls well within Gundlach's expertise. Much like his flagship DoubleLine Total Return, the Flexible Income fund will have significant exposure to mortgage-backed securities. As of the launch date, it had approximately 21% allocated to nonagency mortgage-backed securities, 10% to commercial MBS, and 5% to agency MBS. In addition, it will have meaningful exposure to emerging-markets debt and bank loans.

Expanding the Fleet
Janus and DoubleLine's funds basically fall within the mold of the typical non-traditional-bond fund. Goldman Sachs--which already offers Neutral-rated  Goldman Sachs Strategic Income (GSZIX), the top-selling non-traditional-bond fund since the start of 2013--launched a fund that takes a more distinctive stance.

In March, Goldman converted a long-only closed-end interval credit fund into Goldman Sachs Long Short Credit Strategies (GSAWX). Nontraditional bonds that focus solely on credit and exclude bets on interest rates and currencies are still in the minority. The fund is managed by Goldman's Liberty Harbor team, which was previously the alternatives team at hedge fund Amaranth Advisors (yes, the Amaranth Advisors that infamously lost $4.6 billion in a single week in 2006, but those losses came from natural gas bets, not the credit team).

Investors shouldn't expect many similarities between Long Short Credit and Strategic Income, even though both are offered by Goldman. While Strategic Income has the ability to make bets on duration and any fixed-income security, the long-short credit fund is strictly focused on corporate credit. The two teams also don't share single-trade ideas and aren't even in the same building. Liberty Harbor is headquartered in Greenwich, Conn. 

Because the fund was converted, it has a track record dating back to 2009 (which incidentally ranks as the best in the category), but investors should ignore performance prior to March 2014, when the current strategy was put in place. It's going to take time to prove the hedging process works.

On that front, the fund is similar to the majority of its 84 peers in the category. Two thirds of the funds in the category were launched after 2010 and have yet to encounter the kind of volatile interest-rate and credit environments in which they're supposed to shine.