How Non-Traditional Bond Managers Are Navigating

Non-traditional bond funds have been one of the fastest-growing segments of the actively managed fund industry in recent years. We've written quite a bit about the emergence of these strategies, many of which describe themselves as "unconstrained," "strategic," or "opportunistic." Common denominators of these funds include a broad duration range, sector-picking flexibility, and lower correlations to traditional fixed-income indexes, all with a keen eye on preserving and growing capital while keeping interest rate sensitivity and volatility low.

The "Opportunity or Opportunity Cost" panel at the 2015 Morningstar Investment Conference was a chance to bring together three managers, each from firms with large stakes in non-traditional fixed income funds, to discuss the evolution of their strategies, main inputs into their portfolio construction, and how they expect to navigate the changing market environment ahead.

Moderated by Morningstar's Michael Herbst, director of fixed-income strategies North America, the panel participants included Rick Rieder from BlackRock, Marc Seidner from PIMCO, and Michael Swell from Goldman Sachs, discussing

The panel started off with a discussion of the notable growth in number and assets under management (AUM) of non-traditional bond funds, especially over the last several years. From 2008 through May 2015, the number of non-traditional bond funds jumped to roughly 120 from 24, and AUM spiked to roughly $150 billion from $9 billion. It was clear to the participants that a significant driver of that growth has been investors' fear of impending interest rates hikes, but it's less clear what investors are running toward.

With that, each panel member discussed the goals and targets of their funds and spoke about how they approach the construction of each. The consistent theme remained that these funds are aiming to use a broad range of tools to create consistent returns with lower volatility over various market conditions.

Marc Seidner manages the PIMCO Unconstrained Bond Fund to target a return of LIBOR plus 3% to 4%, with 4% to 6% volatility building across a variety of risk factors. He described five sources of risk that they manage through detailed analytics and research--interest rate, credit, currency, volatility, and liquidity risk--and emphasized that they don't have a favorite. Unlike a more typical core bond fund where the vast majority of the risk is interest rate driven, Seidner's team approaches risk agnostically. They aim to be a value-oriented product that takes on risk exposure from a variety of sources, just as long as they're getting paid for it.

Michael Swell built on the theme that flexibility provided by the unconstrained approach can be a great diversifier for the fixed-income portion of an investment portfolio. He noted that these funds are meant to be a complement to an investor's core bond holding--not a replacement for them. His team aims to generate consistent returns with bond-like volatility while using different risk components than core funds, which he also noted were concentrated in interest rate and credit risk. He argued that non-traditional funds are not a rising rate product, which has been a widely held misconception throughout the market. Instead, according to Swell, these approaches should be viewed as a "best ideas," untethered product that can provide both income and ballast for a portfolio when needed.

BlackRock Strategic Income Opportunities targets a 4% to 6% return per annum above those of 90-day T-Bills and has duration flexibility of between negative two and 7 years. Rieder's team builds the portfolio through an extensive process of market and sector research with risk analysis, looking to uncover the market's most efficient sources of risk. Rieder argued that correlations have changed significantly in the fixed-income markets over the last year and that it's extremely important to understand those shifts when adjusting portfolio positions.

The panel wrapped up with a discussion of variations they've seen in the strategies since the financial crisis and what changes they expect in the market environment ahead. The fact that this is still a young and very heterogeneous category was highlighted, making generalizations about the group difficult. Yet all agreed that there has been a shift for most since 2008 from an income- oriented at any cost approach to a much more diversified absolute return approach that the panel felt will better serve investors by limiting unexpected volatility.

The panel also conceded that we're entering a time of increased volatility spurred on by economic divergence throughout the world, reduced market liquidity, and shifting central bank policy. To prepare, they've reduced risk and have focused on boosting liquidity. They argued that this will allow them to take advantage of the inevitable opportunities that present themselves in a more volatile market. Research and analysis will remain paramount as the opportunity set for these funds change, but all were confident that they have the flexibility and tools to meet any new challenges.