The Great Realignment: One Approach To Unconstrained FI Investing

The Great Realignment: One Approach To Unconstrained FI Investing

Despite tapering, investors can expect to be in for a sustained period of low interest rates, and in such a situation eking out a better return on a fixed income investment can be a challenge.

Traditional bond funds, which are benchmarked to indices such as the Barclays US Aggregate Index, suffer from interest rate risk and lack the flexibility to adjust their portfolios on the fly when the interest rate regime hardens.

Fixed income investing: Benchmark-agnostic strategies

These are fixed income investing strategies that are not linked to a single fixed income index or sector as in the case of a traditional bond fund.

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Also called “go-anywhere” funds, these unconstrained funds can be actively managed by skilled portfolio managers to take into account changes in market dynamics. The Barclays US Aggregate Index is known to have a bias for longer term, investment grade securities.

However, an unconstrained fund could limit the fallout from an adverse interest rate development by diversifying into more suitable duration investments, or otherwise hunt for more niche or unconventional opportunities in the fixed income spectrum.

Skill, agility and costs are paramount

By their very nature, unconstrained funds counter-balance the limitations of traditional benchmarked fixed income investing through better timing and selection depending on the skills of the manager.

Last week, the PIMCO Unconstrained Bond Fund Institutional Class (MUTF:PFIUX) was downgraded by Morningstar Inc. “While there’s a reasonable case to be made that the fund’s more modest overall performance is a fair trade-off for taking less credit risk, it’s more difficult to champion the fund as a competitive non-traditional alternative to core funds when it has displayed comparatively high correlations to those funds’ key risk factors while still producing weaker returns,” wrote the Morningstar analysts, as quoted by Bloomberg.

A January 2014 study of unconstrained funds said data from the last three years showed that in fact, unconstrained funds, on average, did not fulfil their promise of strong performance irrespective of market environment.

The study recommended that investors should consider all three categories of funds, namely, unconstrained, intermediate-term and longer term, and that unconstrained funds could prove to be laggards because of their higher expense ratios. “Lower correlation has helped performance, but the most reliable way to improve returns is through lower expense ratios,” said the study.

“The great realignment”

Nonetheless, “Investors are increasingly looking to ‘next generation debt strategies,’ investing more globally and leaning to more benchmark-agnostic strategies,” says an April 2014 study by Dick Oswald and Marika Dysenchuk, Client Portfolio Managers at Global Fixed Income, Currency and Commodities, JP Morgan Asset Management.

The advantages of these unconstrained and flexible strategies are:

  • Flexibility to change sector and duration exposures
  • Access to the entire global fixed income universe
  • Additional diversification benefits
  • Lower correlation to each other and the U.S. Treasury rates

On the flipside, go-anywhere strategies suffer from not having the simplicity and clarity of performance that is visible to investors through a benchmark index, as well as the substantial variance in the risk and return dynamics of these funds compared to a benchmark fund.

JP Morgan’s Multisector Income Strategy (unconstrained)

The JP Morgan analysts executed a study comparing the above strategy with a Core Bond Strategy (traditional), back testing it across periods that included rising as well as falling interest rates.

The rising interest rate scenario included two phases when interest rates rose higher. The study found that in both cases the Multisector Income Strategy outperformed the Core Bond Strategy as well as the Barclays Agg index.

In a falling interest rate situation, the Multisector Income Strategy underperformed during the period April 2012-July 2012 (when bonds rallied) because of a conservative duration policy. During 2013, however, the strategy did better because of its higher yielding holdings, observes the study.

2-falling rates Fixed Income

Mix-and-match strategies with the Core Bond Strategy

In the concluding part of their analysis, the authors back tested various permutations and combinations of a mix of the Multisector Income Strategy with the Core Bond Strategy, ranging from 100% of one strategy to 100% of the other.

“Over the full period for analysis (March 31, 2012-August 31, 2013) a combination of our code and multi-sector strategies outperform the Agg, with improvement in returns and Sharpe ratios as the unconstrained proportion increased,” remark the authors.

3-mix-and-match Fixed Income


Investors may consider a realignment of their fixed income portfolios with an introduction of unconstrained strategies.

“By incorporating strategies with more flexibility to change duration and sector exposures, managers are able to more freely seek out the most attractive risk-adjusted return opportunities that the markets have to offer, while still maintaining the characteristics of a bond portfolio,” recommends the research note.

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