Reaching for Yield

Reaching for Yield—Non-Traditional Bond Funds

Reaching for Yield

In late 2011, a few years after the beginning of the current era of very low interest rates, Morningstar launched the non-traditional-bond category. According to Morningstar’s Eric Jacobson, this category includes funds that pursue strategies that diverge in some way from conventional practice in the bond-fund universe. One hallmark of non-traditional bond funds is their use of leverage and derivatives to either hedge or increase particular risk exposures.  Like inverse bond ETFs, some of these funds structure their holdings to benefit from an increase in interest rates, which means the funds would lose value if interest rates fall. Other bond funds are placed into this category simply because they are unconstrained with respect to the types of bonds they can buy (i.e., any maturity and any level of default risk). Essentially, they are another variant of “go-anywhere” funds which we wrote about here.

As of today (8/15/2014), based on data from Morningstar Direct, there are 86 distinct funds managing $154 billion in this category. These numbers are more than double what they were at the time the category was introduced. Compared to the $3 billion that existed in January 2009, this category can be fairly said to have exploded. The two funds that dominate the category are PIMCO Unconstrained Bond (PUBAX) at $21.7 billion and JPMorgan Strategic Income Opportunities (JSOAX) at $26.9 billion. Naturally, we were curious to see how investors have done in those funds over the past few years. The table below shows that their performance is nothing special.

One potential problem that we see with non-traditional bond funds is the tendency for many of their investors not to understand the risks that the manager is taking. A recent article in Time highlighted this issue for both traditional and non-traditional bond funds. For example, the current asset allocation shown on Morningtar.com for the $223 billion PIMCO Total Return Fund (PTTAX) shows it with -35.3% cash and 133.6% bonds. Morningstar does not even attempt to assign an average credit rating. This fund has recently suffered from investor withdrawals, which we wrote about here. While the Time article correctly identified the problem of bond funds taking on unnecessary and potentially harmful risks, its solution of diversifying among both active managers and index funds was off the mark, in our opinion.

In closing, we wholeheartedly agree with Mr. Jacobson’s assessment that non-traditional bond funds are “more a triumph of marketing than of investment acumen”. If you would like to learn more about the important role that traditional bond funds play in a balanced portfolio of index funds, please give us a call at 888-643-3133.