Bond markets are presenting investors with multiple challenges. Rates remain low by any historical measure, although they are starting to rise. And with yields low, expected bond returns are low as well, and for the first time in several years portfolio duration represents a rising risk. The situation is further complicated by the fact that following years of ultralow rates and investors chasing yield, credit spreads are compressed. In other words, marginal returns from taking credit risk are also likely to be modest.
In this environment, we believe investors should consider employing unconstrained bond funds as another tool in their arsenal. These strategies exploit a broader universe of fixed income instruments, allowing managers greater latitude to search for yield and manage risk. In an environment in which opportunities are often fleeting, they also provide flexibility to adopt a more tactical stance. The challenge for investors is that the risk characteristics of unconstrained strategies can be quite different from traditional bond funds. This complicates the portfolio construction process.
Given that flexible fixed income strategies will often have lower durations and more credit exposure, a “one-for-one” swap of unconstrained fixed income for a traditional bond fund is rarely the optimal solution. Instead, the allocation problem is partly determined by the investor’s allocation to other asset classes, particularly equities. In general, ex-ante allocations to unconstrained bond funds tend to be highest in portfolios with low to modest equity allocations. In a similar manner, the allocation to an unconstrained bond fund in an all-bond portfolio is heavily influenced by the amount of credit in the rest of the portfolio.