Sunday Musings: Unconstrained Bond Funds

Yesterday, I talked about how to deal with the potential of rising interest rates. What if you need to continue generating income in the face of higher rates? Losing more in principal than receiving in dividends is hardly the way to come out ahead.

MarketWatch offered some alternatives in “Bond funds that shield you from interest rate risk:”

The smart money is well aware that investing in bonds these days is risky business, especially bonds with long-term maturities, but investors are also well aware they need to allocate some portion of their assets to fixed-income securities. The question is, which ones?

Any increase in interest rates will send the value of long-term bonds straight to the mat, much the same way Mike Tyson punched out Zach Galifianakis, as Alan Garner, in the movie “The Hangover.”

For his part, Harold Evensky, the chairman of Evensky & Brown, one of the nation’s most respected investment firms, has decided not to answer that question — at least not directly.

Since no one really knows when interest rates will rise and bond prices will fall, and since investing in bonds the old-fashioned way is really old-fashioned, Evensky is putting a portion of his client’s portfolios into what are called “unconstrained” bond funds.

Unconstrained bond funds are a relatively new breed of funds where the manager has the ability to invest in most any type of fixed-income security they want. The manager can go long or short on the yield curve, buy U.S. or not, developed markets or emerging, and investment grade or junk. In essence, they can do whatever they want. Even better, they are not tethered to a benchmark or index or category.

“These are blue-sky funds,” said Eric Jacobson, Morningstar’s director of fixed-income research and editorial director of its fund research group. “The managers can do whatever they think is best.”

And therein lies part of the appeal of these funds. The two big funds in this small but increasingly popular category are managed by the best of the best. The PIMCO Unconstrained Bond fund (PUBAX). PUBAX is one of several share classes available) is managed by Chris Dialynas, who has 32 years of investment experience.

The J.P. Morgan Strategic Opportunity fund. JSOAX is one of several share classes available) is managed by Bill Eigen III, who has 18 years of experience, having cut his teeth managing bonds for Highbridge Capital Management and Fidelity Investments. (Another fund in this category is the Harbor Unconstrained Bond Fund (HRUBX) , which happens to be subadvised by Pacific Investment Management Company LLC, otherwise known as PIMCO.)

To trust….or not?

In most cases, giving managers free rein to invest however they see fit in hopes that it will all work out is a recipe for eventual disaster.

“It’s a really tall order to ask someone to deliver positive returns and eliminate interest-rate risk,” Jacobson said. Rare is the time, he said, when he would have sufficient trust to give money to a manager to do anything they want. “It’s easy to make mistakes,” said Jacobson, who plans to initiate coverage of the aforementioned funds in the next few weeks.

Let’s look at performance first. Over the past 2 years JSOAX has been the clear leader; over the past 12 and 6 months periods, BND (as comparison) came out ahead, while during the most recent 3 months period (shown in chart above), JSOAX moved into the lead again.

The unknown is how quickly will fund managers change gears and go from long to short, should rates rise. I have always recommended avoiding making emotional decisions by “staying with a trend until it ends when it bends.”

This bending at the end, if in fact we have reached it, is clearly visible in the above chart, as all fund prices have recently shown downward bias, but have remained above the long-term trend line.

With a potential bond bubble brewing, the jury is still out as to whether these types of bond funds will really protect you in time if and when rates shoot up. Personally, I doubt it. These funds remind me somewhat of the much touted Long/Short funds, which never really lived up to their promise of making money in either market.

Additionally, two of the three funds featured above have front end loads of 3.75%, which I find not acceptable in an era of sliding fund/ETF expenses, especially when considering that this is an unproven product.

My preference, also in regards to bond funds, is to watch the trend and exit when my sell stops get triggered. I will then sit in cash and evaluate the investment landscape before making any new commitments.

We’re in unchartered territory with the Fed’s QE-2 and its possible unintended consequences, which makes me not very eager to seek exposure to products that have not been tried.

Disclosure: Holdings in BND

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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