Are Unconstrained Bond Funds the Answer to Rising Yields?

Bond yields are set to rise later this year and when they do prices will fall. Fund managers have pre-empted this by launching unconstrained bond funds - but which one is for you?

Emma Wall 28 May, 2015 | 12:15AM
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Emma Wall: Hello and welcome to Morningstar. I am Emma Wall and I'm joined today by Oksana Aronov, Portfolio Manager for JP Morgan.

Hello, Oksana.

Oksana Aronov: Hi.

Wall: So I met with your colleague Bill Eigen at the tail end of last year and he came up with a fantastic comment 'bond funds beware', because it's a case of when, not if, bond yields are going to come up and bond prices are going to go down. So if you are in a long-only bond fund, you're in trouble.

So, the market has responded. There has been flood of these strategic bond funds, unconstrained bond funds that seemingly have the answer to investor's prayers. But I don't think a lot of investors know exactly, what they are. I mean what are they?

Aronov: Well, it's a very interest question because at the end of the day when we think about fixed income, fixed income is about capital preservation, portfolio diversification and income when the pursuit of income does not put your capital at risk. And so what's a capital preservation-oriented investor to do in today's environment if switching into higher quality assets makes them more interest rate sensitive and we saw over the first few weeks of this month as well as during the taper tantrum last year that, that can be pretty volatile proposition.

So the industry answer to this has been this proliferation of unconstrained strategies, they are the new panacea and the answer to all of your troubles. But of course investors have to be quite discerning in terms of what they are buying, what's under the hood of these strategies. They have to ask the right questions to understand whether the goal of the portfolio manager is aligned with their goal and whether the risk, the portfolio manager is taking is aligned with their risk appetite.

Wall: We have seen some negative sentiment around absolute return when it comes to equities, because some of these strategies haven't done what they said on the tin. You are expecting capital preservation. You are expecting real returns after inflation and actually due to some hedges that didn't quite pay off, absolute return haven't absolutely returned. Are those risks associated with fixed income, absolute return strategies as well or is it something that's more likely with equity strategies?

Aronov: Well fixed income absolute return strategies really are about capital preservation first and foremost, and that means to the extent that they are using alternatives, they tend to generally shy away from things like leverage. I mean mangers get into trouble time and time again when they lever up these types of trades and that's where a lot of the underwhelming performance probably has come from in the equity space.

Also, when we think about absolute return strategies and fixed income, they make liberal or should make liberal use cash. Using cash strategically is exceptionally important especially in today's environment of transient liquidity and you're now seeing and hearing a lot about this topic and it's on Bloomberg every day and regulators are talking about it.

It really has to do with the structural change in the market where the shock absorption mechanisms that use to lend their capital, when volatility came into the market are no longer there. Dealer inventories are plummeting. You have a market much more dominated by instantaneously liquid instruments such as ETF, so there is perhaps a mismatch between the holding horizon of some of these vehicles and the street's ability to transact.

Wall: We've actually seen the FCA in the U.K. warn bond fund managers about this liquidity. As you say it's because there has been this removal of the buffer prior to the credit crisis, the global recession, investment banks would act as you say as a trade in between the buyer and the seller, and they would hold liquidity for those individuals. Now those people have gone, we need to be careful about cash. We need to make sure much like property funds got into trouble you need to have that cash buffer, so that you can make trades.

Aronov: Absolutely, cannot overemphasise the importance of this. This is a real opportunity for the buy side to become that liquidity provider, however unfortunately for the most part, the buy side remains nearly fully invested because it's much easier to have a conversation with the client about maximizing yield and maximizing their total return as opposed to minimizing risk. I think today investors would serve themselves as well, to think about that minimizing risk potential.

Wall: So, how do investors go about that? Is it as simple as looking at the different funds available to them and seeing what cash allocations those funds have? Are there any sort of tips to make sure you are taking on the risk that's appropriate to you?

Aronov: So, to the extent that – the first thing to do is to, identify the goal. And if the goal is capital preservation, and if you do want to achieve it by going into some of these absolute return strategy, you cannot get there without a team that's got experience with the alternative strategies that we're talking about here.

A team that has demonstrated the ability to be truly differentiated across different parts of the market cycle in other words, holding cash when they are not being compensated for risk, deploying it into the market when they are, and so it takes experience, you want to see that and you want to see a history of being able to survive or I guess manage through volatile periods.

Wall: Oksana, thank you very much.

Aronov: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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Emma Wall  is former Senior International Editor for Morningstar

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