While good defenders against interest-rate risk, nontraditional bond funds generally take on more credit risk than core bond funds and carry higher expense ratios, too.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Nontraditional bond funds proliferated earlier this decade amid concerns over rising interest rates. Now that some of these funds have amassed significant histories, it's a good time to check in to see how well they've served investors. Joining me to discuss that topic are two of Morningstar's senior fixed income researchers, Miriam Sjoblom and Eric Jacobson.
Miriam and Eric, thank you so much for being here.
Miriam Sjoblom: Thank you, Christine.
Benz: Eric, let's start with you. Let's talk about that environment that stoked the proliferation of these products. Why did so many of these funds start to come to market around the same time?
Eric Jacobson: Well, a lot of that was pretty close after the financial crisis, and as you'll recall, the government stepped in with a lot of extraordinary measures to try to help keep this system from falling apart and certainly, to sort of refloat the economy after the financial crisis. A lot of those measures were things that people are worried about in terms of causing lots of inflation. People expect that those kind of policies will feed inflation and eventually rising interest rates. That fear of rising rates really started to take over very shortly after the crisis and everyone was really looking for something to supplant their otherwise very rate-sensitive portfolios and especially so as Treasuries shot up as well.
Benz: So, investors were--or maybe institutional money managers were sort of looking at this environment and saying, in such an environment you don't want to be in a very rate-sensitive bond portfolio; you want to be in something else. So, let's talk about in practical terms when you look at the complexion of these funds what sorts of holdings do they have and what was the thought on how they would perform in that rising-rate environment?
Jacobson: One of the key themes is to eliminate or slash interest-rate risk. What we've seen though is that in order to maintain some sort of competitive posture most of those funds while cutting back on interest-rate risk, have taken on some other kinds of risk. Generally, some sort of credit risk, whether it's high-yield bonds, emerging-markets debt and so forth, things that maybe have a little bit less liquidity depending on what we're talking about. But by and large, lot less interest-rate risk, a lot more credit risk.
Benz: So, fairly, short durations but taking more risk on the credit side. Miriam, when you look at these funds and how their portfolios change over time, do the managers tend to be pretty active? Are they jockeying around amid different bond market sectors or do they tend to be pretty steady in terms of their positioning?
Sjoblom: It can really depend a lot. Depending on the given strategy or the individual fund. While the trends that Eric mentioned have been overall true, little interest-rate risk, more credit risk, how managers go about doing that has varied widely. If you just look at the duration management that the funds use in the category, a lot of these funds have flexibility to go very long duration, eight or 10 years in some cases, or short, even negative duration of negative three years, negative five years on the extreme end. But how much managers will take advantage of that flexibility really depends.
There is a Goldman Sachs fund, Goldman Sachs Strategic Income, that has been using, taking fuller advantage of that flexibility. Its duration has been long as long as four years, as short as negative three years. Meanwhile, BlackRock has got a fund, Strategic Income Opportunities, that has the same degree of flexibility as the Goldman fund, but their duration over the past five years has been really more in the zero to two range. So, PIMCO Unconstrained, another well-known fund, since about late 2014 they've actually had a slightly negative duration this whole time. So, not a lot of moving that around. It really just depends, you have to look closely at the specific manager and investment style when you are choosing one of these.
Benz: So, you and Eric recently completed a white paper where you took stock of this whole category. You looked at the composition of some of the main funds in the category and you also did a deep dive into performance. So, Miriam, let's talk about that. How have these funds performed? And of course, they all had different inception dates, but when you, kind of, look at them in aggregate, what does performance look like relative to, say, the Barclays Aggregate Index?
Sjoblom: Well, so, this one problem that they are trying to fight against, the problem of rising bond yields, we haven't had a lot of pronounced instances. So, we took a look at a few instances where Treasury yields, the yield on the 10-year Treasury, rose by 0.5 percentage point or maybe more than that and in general, these funds did do a pretty good job of delivering positive returns, not in every case, but holding up pretty well versus core bond funds during periods of rising Treasury yields.
Benz: So, like 2013, I think there was, sort of, what did they call it, the taper tantrum that period …
Sjoblom: And that's actually a period that was an exception because you had a rare instance where Treasuries sold off, but also high-yields sold off. So, if managers were diversifying away from Treasuries by owning credit-sensitive assets, they also experienced some losses. They did generally hold up better than core bonds funds though, but did experience some losses during that stretch.
Benz: So, during that particular period nontraditional bond funds didn't look all that great?
Sjoblom: Exactly. Yeah. And then, we also took a look at periods of troughs for the S&P 500 and what you saw there is intermediate-term bond funds were delivering gains along with the Barclays Aggregate during those periods. Nontraditional bond funds on average were experiencing losses.
Benz: So, one thing that I know you both think about, I certainly think about, is how these different investment types fit together into a portfolio. So, when you take a step back, and look at this category, look at how these funds have served as diversifiers, how do you think about them within the context of maybe a plain-vanilla equity, plain-vanilla bond portfolio?
Sjoblom: So, how these funds have been marketed is providing diversification away from traditional core bond portfolio. They have been pretty successful at that. Their correlations to the aggregate bond index have been quite low and even just isolating the Treasury component of the aggregate bond index they've actually had slightly negative correlation to Treasuries. So, all you're concerned about is getting diversification away from bonds, these have been reasonably effective at that; however, correlations with other sectors, like high-yield credit, equities, has actually been pretty high for this group. So, while you're getting diversification away from traditional bonds, you're getting not such a good diversification away from your higher-risk portions of your portfolio. So, what do investors want out of their bond holdings? I think that the case for a nontraditional bond fund as a good substitute for a core bond fund isn't really there so far.
Jacobson: Well, and one of the big reasons that I think that's kind of the dangerous concept is that if you're diversifying away from your core bond exposure then pretty much what you have left, as Miriam suggested, is something that has a lot of equity market exposure, high-yield market exposure, etc., no interest-rate exposure or very little if you're supplanting your core bond fund. The reason that that can be a problem is that during periods of high market stress, especially when they are linked to the kinds of equity market sell-offs, high-yield sell-offs and so forth, the only thing, generally speaking, that performs well in those situations is Treasury bonds. And if we go back and look at 2008, it's obvious that it's kind of an extreme example. But Treasury bonds were the one thing that buoyed portfolios that were otherwise getting killed during the financial crisis. We may not see something quite like that again. But if you go back and look at periods like that, it's pretty much the only kind of insurance policy that most people have in their portfolios.
Benz: So, that very simple diversifier has been pretty effective. In the research paper you also highlighted some additional headwinds that these funds are facing, could face in the years ahead. Let's talk about some of those. Regulatory risks as well as the fact that these funds aren't especially cheap. Eric, can you highlight some of those issues?
Jacobson: Sure. The regulatory risk is not necessarily aimed directly at unconstrained--I'm sorry--nontraditional bond funds. That's our catch-all term, unconstrained and absolute return bond fund sort of all fit under there. But there is a lot of regulation being discussed right now that may pull back on funds' abilities to use derivatives. And a lot of these funds use quite a few derivatives in order to achieve the goals that they are trying to do, including, for example, just shorting Treasuries. But a lot of it as well can be construed as coming afoul of the kinds of regulations that the SEC is proposing to implement right now. If that were to happen, I think there are a lot of funds that would find it very difficult to continue managing the way that they are.
As far as the cost picture is concerned, that's a big conversation, because we always talk about costs as being an issue here at Morningstar, and we talk about it in terms of conventional bond funds as well. But even against that backdrop, these are very expensive funds. The justification is often that they are somewhat hedge fund-like and so forth. But most of the firms that run these funds are doing so with the same capabilities that they had before. They are just charging a whole lot more. And when I say a charging a whole lot more, I mean, big gaps between what a conventional intermediate-term bond fund might charge and what these are charging. And the real problem there in addition to everything else, is that the potential returns going forward are relatively modest, especially when you're talking about funds that are benchmarking themselves off of LIBOR, a very, very short-term interest-rate paying almost nothing right now with a modest margin over the top. A 1% expense ratio is going to true up a huge amount of that going forward.
Benz: Miriam, let's talk about the investor experience in these funds. I think if we were all to sort of look at this five years ago and say, well, maybe not the worst idea I've ever seen. But in practice, investors have not purchased these funds at particularly opportune times and it looks like they've been selling more recently. Let's talk about that, whether investors have undermined their own results with their timing decisions.
Sjoblom: So, when we first launched the category back in 2011, it had already amassed about $50 billion in assets and grew to its peak of $160 billion, so very quickly more than tripled by September 2014. Since then it appears investors have kind of gotten fed up with not seeing the results that they've been promised, not seeing very detrimental period of rising yields. So the category now is down from $160 billion to around $120 billion and I'm including long-short credit which is a small subset we recently broke out into its own category. But taken those together there have been outflows from both groups. So, investors have left money on the table over the past five years. I think it amounts to comparing investor returns to total returns about 1% annualized. So, that's a lot. We actually did look at this though relative to the intermediate-term bond category at the same time and the differences are significant, which kind of goes to show you that I think investors have had trouble timing when is a good time to get into the bond market or to get out.
Benz: Eric, would you say that these funds are a marketing gimmick in a way?
Jacobson: I won't point my finger at every single fund firm. There are reasons why some folks have legitimate reasons why they think that they are a good idea. But generally speaking, this is kind of a cynical thing. These were products that were either launched or funds that turned into these kind of products right around the time when panic was really high about rising interest rates. They were sort of sold on some ideas and promises that right from the get-go, in many cases, looked like things that most managers were not going to be able to deliver at the same time and I think managers have tried to manage them well in those cases. But by and large, I think the overarching concept is pretty gimmicky.
Benz: An all-too-familiar story. Thank you so much for sharing this research. Thanks for your insights.
Sjoblom: Thanks Christine.
Jacobson: Thanks Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
