A Fire Drill For Unconstrained Bond Funds

The Federal Reserve is expected by many in the financial sector to begin increasing interest rates soon, and financial planners should be prepared for investors to look to managers of these unconstrained bond funds to protect themselves.
However, attempting to figure out what the managers of these new seemingly unlimited funds are doing is confusing—managers can buy any securities that they desire whenever they desire. They also have the freedom to do things like sell Treasury bonds short as well as fill portfolios with things like derivatives.
It’s a difficult way to plan investments as the average unconstrained bonds have 198% turnover—the securities that attract your investors to the funds now could be completely swapped out by year’s end.
Following the mechanics of these types of bonds has become so convoluted that top analysts at existing fund research firms like S&P Capital IQ and Morningstar can’t get a firm understanding on what these ‘go anywhere’ bond funds are doing with their portfolios.
It’s not uncommon for investors to choose their funds based on their desire not to be bothered with the nuances of how the managers are handling these funds. Financial advisors need to explain to clients that when they make these changes and switch over to an unconstrained portfolio, they are lowering their interest rate risks but inheriting manager risks.
If the fiscal quarter ending June 30, 2015, was any indicator, investors have a right to have concerns. 9 out of the ten largest ‘unconstrained’ bond funds underperformed the Barclays US Aggregate index in the trailing 12 months—managers placed their portfolios in position for the Fed to raise rates last year and were mistaken.
Unlike intermediate-term bond funds’ portfolios, these unconstrained bonds can have a long, short, or even negative duration. This is a measure of a fund’s sensitivity to interest-rate changes—going shorter or negative duration is an investment strategy that is best left to when interest rates are expected to rise.
Negative duration bond strategies can give investors an opportunity to profit from a situation where rates rise, and overall bond fund prices fall. This is achieved by taking a ‘short’ bond position through Treasuries or Eurodollar futures. Conversely, a negative-duration Portfolio could underperform or even suffer losses if rates fall.
If the Fed makes the decision not to raise rates, investors in many unconstrained bond funds will likely be disappointed if bond prices rise.
Another problem lies in the matter with which fund companies disclose and value derivatives in their portfolios. Most firms report such metrics differently creating quite a murky territory for the average investor.
The SEC is currently working on rules to standardize the way that firms use derivatives in their bond funds and how they disclose the use of them in their portfolios.