Unconstrained fixed-income strategies, while popular with institutional investors as a way to reduce interest-rate risk and remove benchmark constraints, could be exposing investors to a whole new set of risks, industry experts say.
These strategies have grown very quickly in popularity over a short period of time. Data from Marietta, Ga.-based eVestment LLC show that as of Dec. 31, institutional global and U.S. unconstrained bond mandates drew $461.8 billion in assets, up nearly 170% from Dec. 31, 2010.
Many of these strategies were designed to provide higher yields while protecting against rising rates. But in recent years, unconstrained funds have been highly correlated with high yield, leveraged loan and emerging markets debt funds.
As a result, sources say investors need to be really clear on their objectives for the investments — those expecting their fixed-income allocation to provide safety during market turbulence might be disappointed with unconstrained bond funds.
Since April 17, the yield on 10-year U.S. Treasuries has spiked 37 basis points, to 20%. The move in the German 10-year bund yield since April 21 has been even more pronounced — 63 basis points, an 840% increase.
During that time unconstrained offerings appear to have performed as expected and insulated investors from interest-rate volatility.
The Barclays Capital U.S. Aggregate Bond index is off 1.81% since April 17, while unconstrained bond mutual fund offerings from Pacific Investment Management Co. LLC, BlackRock Inc. and J.P. Morgan Asset Management have returned 0.26%, -0.11% and -0.12%, respectively.
Year-to-date the Barclays U.S. Aggregate index is up 0.24%; BlackRock's Strategic Income Opportunities Fund, J.P. Morgan's Strategic Income Opportunities Fund and PIMCO's Unconstrained Bond Fund returned 1.38%, 1.17% and 0.49%, respectively.
“There's no such thing as a free lunch,” said Bill Martin, a managing director and head of fixed-income portfolio management for TIAA-CREF, Charlotte, N.C.
By removing interest-rate risk, investors can gain all sorts of new kinds of risk, including credit risk, managerial risk and an overall lack of transparency, Mr. Martin said in a phone interview.
In addition to these risks, the complexity of such strategies can make evaluating performance difficult.
Though most experts with whom P&I spoke weren't against the idea of institutional investors allocating to unconstrained, they believe investors need to do be acutely aware of what their managers are doing and understand that unconstrained is not the capital-stabilizing portion of the portfolio.
Jes Staley, managing partner of BlueMountain Capital Management LLC, New York, said, “Although there's no inherent problem with unconstrained bond funds ... we all benefit from transparency and clarity around how money is managed. And I do think that we need to make sure that investors in such funds know exactly what they're investing in.”
“It's OK to be in unconstrained fixed income, as long as (investors) recognize it's not capital preservation,” said John Skjervem, chief investment officer at the Oregon State Treasury.
Priscilla C. Hancock, a managing director and global fixed-income strategist at J.P. Morgan Asset Management, New York, said in a phone interview that with unconstrained strategies, several different kinds of stress-testing need to be done. “You have to look at correlations; not only to a benchmark, but across different asset classes, and across things not even connected to fixed income, like oil, GDP and currency,” Ms. Hancock said.
Ms. Hancock warned though that “when you move away from benchmark risk, you gain manager risk.” For example, Ms. Hancock said a manager adept at investing in constrained fixed income might not necessarily be skilled at investing in unconstrained.
Robert Schmidt, manager of the Brandes Institute at Brandes Investment Partners LP, San Diego, said with all of the “credit risks associated with allocating to an unconstrained bond fund,” he believes the approach is “not a very clear way to invest in fixed income.”
Mr. Schmidt said unconstrained managers by their nature can invest in different sectors of the market, at different points along the yield curve, in various securities.
The problem with this “go-anywhere” approach, though, is that it makes it very difficult for investors to monitor the manager and get a sense of the reasons behind performance, he said.
Oregon's Mr. Skjervem said unconstrained strategies can be “a story that potentially ends in tears based on the way they're marketed and in some ways implemented.”
Timothy Doyle, a Milwaukee-based fixed-income portfolio manager and analyst for the Brandes Investment Partners' fixed-income group, agreed. “Fixed income has traditionally been (used in portfolios) to dampen equity volatility,” Mr. Doyle said. “We don't mean to disparage the unconstrained asset class, but we want (investors) to step back and really think about their fixed-income position.”
The main reason for this difficulty in understanding the intricacies of any unconstrained strategy, according to several sources with whom Pensions & Investments spoke, is that there are just so many strategies that carry the label of “unconstrained.”
Michael J. Collins, senior investment officer and credit strategist for Prudential Fixed Income, Newark, N.J., likened unconstrained fixed income to the “Wild West.”
“The different styles are so disparate and varied,” Mr. Collins said. “But what they tend to have in common is very little interest-rate sensitivity. That attracts (investor) interest.”
The lack of transparency from money managers is another challenge that institutional investors face when allocating to unconstrained fixed income.
“It's tough to get a sense of what these managers are doing. They can turn on a dime,” Brandes' Mr. Schmidt said. “It's far better (for managers and asset owners) to have a disciplined process.”
TIAA-CREF's Mr. Martin said unconstrained fixed income is “a new fund construct that hasn't been tested across the full market cycle. It's a bit of a post-crisis phenomenon.” n