The bond market is> a scary place these days. Treasury yields are low, the muni market is still a mess, and both high-quality corporate and junk bonds are getting expensive. To try to cope in this whack-a-mole investing environment, fund companies are sporting a new mallet: Bond funds that give the managers complete freedom to buy whatever fixed income securities they want.
It's an unprecedented amount of latitude for bond fund managers, but these new funds called "unconstrained" or "go-anywhere" bond funds are replicating like rabbits. Four such funds have been launched in the last year; in total, there are now 13, with $38.5 billion in assets. With more expected, fund-rater Morningstar is considering creating a new category to represent these funds. "The number of funds has just exploded," said Eric Jacobson, a fixed income specialist at Morningstar.
The closest thing to these funds currently on the market is what are known as multisector bond funds, which invest in different sectors of the bond market as well. The key difference is that the managers of multisector funds must follow the weightings of whatever benchmark they track, so if 30% of the Barclays Aggregate Bond Index is comprised of U.S. Treasurys, a multisector bond fund tied to that index must mimic that proportion.
In the new funds, there are no such constraints (though fund shops may choose to set some limits). Instead, the goal is often to do better than a cash-based index (often the London Inter-Bank Offer Rate, or the Libor). It's not a very high bar right now: The 3-month Libor returned less then 1% in 2009 and 2010. Regardless, the managers can do whatever they want to beat it, manipulating cash holdings, credit quality, and duration however they see fit. Some can even use derivatives to push the average duration of the fund negative, which would allow the fund to make money if interest rates go up, rather than lose it, as with traditional bonds. This is a particular boon, fund managers say, because it enables them to cancel out the interest-rate sensitivity of longer-term bonds, while still taking advantage of their higher yields.
The funds may appeal to investors who are willing to bet on a manager, says Matthew Tuttle, a White Plains, N.Y., financial adviser who uses unconstrained funds. And many of these funds have already amassed enough assets and performance to gain the attention of financial advisers. For example, the top two performers over the past year include the $1.7 billion BlackRock Strategic Income Opportunities fund,
Like any strategy based in part on market timing, managers can be as wrong as they are right, and they make be taking positions that are riskier than you may be comfortable. But because the funds are so new, most fund managers haven't had the chance to prove themselves yet, says Tuttle. Plus, some sector bond funds are still doing just fine: High yield bond funds returned 14.2%, and intermediate-term bond funds returned 7.7% in 2010 significantly better than Pimco's Unconstrained Bond fund
Advisers recommend choosing a fund manager with a strong fixed income track record, even if the fund itself is fairly new. In spite of its middling performance, Jacobson likes the Pimco Unconstrained Bond Fund, in part because lead portfolio manager Chris Dialynas sits on Pimco's investment committee with Bill Gross, which meets for several hours a day, and has been running institutional money for Pimco for 30 years. The fund has returned 4.45% over the past 12 months, slightly underperforming the Barclays Capital Aggregate Bond Index, and charges 1.30%, or $130 for every $10,000 invested. Gregg Millman, a financial adviser in Wilmington, Del., recommends the JPMorgan fund, which has gained 6.06% over the past year and charges 0.91% or $91 for every $10,000 invested.