20
Bond yields confounded investors in early
2014
by
mostly falling at a time when so many were expecting
them to rise. Not surprisingly, fund investors turned
to nontraditional bonds for help. The category saw
more than
$50
billion of inflows in
2013
and another
$19
billion during the first five months of
2014
.
The trend has been fueled mostly by investors' con-
tinuing fear of rising yields, and much of the money
going into the category has been reported to be
coming out of core bond funds, most of which reside
in the intermediate-term bond Morningstar Category
and are benchmarked to the Barclays U.S. Aggregate,
the bond market's version of the S
&
P
500
.
Most non-traditional-bond funds are sold on the
premise that investors can protect themselves from
rising yields by giving managers broad flexibility to
manage interest-rate sensitivity—in contrast to core
funds that keep their rate sensitivities in range of
their benchmarks—yet still earn returns competitive
with those expected of core funds.
Most managers in the category haven't made dramatic
interest-rate bets, though, and in fact have kept
their durations (a measure of interest-rate sensitivity)
relatively short in recent years; most recently the
category median was around
1
.
6
years, while the
average intermediate-term bond fund clocked in
around five years in May
2014
.
There's a natural conflict, however, between trying to
mitigate interest-rate volatility by keeping a fund's
duration short and still generating returns competitive
with those of intermediate-duration funds. When
interest rates aren’t surging, the only way to make
that happen is to take other risks to compensate
for the return potential lost by keeping a fund's rate
sensitivity low for a long time.
Most funds in the category can build very large expo-
sures to junk bonds, emerging-markets debt, and even
foreign currencies, and most are taking on credit risk
of one kind or another. The average intermediate-term
bond offering has around an
11%
exposure to below-
investment-grade bonds, while the average nontradi-
tional fund carries more than
3
times that amount
with an average
36%
weighting.
The market hasn't endured a sustained sell-off among
credit-sensitive bonds since the
2008
financial
crisis, however, so most funds that have sprouted up
in recent years haven't been tested by much adver-
sity in the credit markets.
If there is a useful period to examine, though, it's
2011
. Europe's banking crisis spread panic around
the world during that year's third quarter, investors
dumped most credit-sensitive debt, and money
flooded into U.S. Treasury bonds. Funds that had
stripped out most of their interest-rate sensitivity
therefore saw double trouble. Their riskier assets fell
in price, yet they didn't have the insurance that
sensitivity to U.S. rates otherwise provided to core
funds. As such, the average intermediate-term
fund outpaced the average nontraditional offering
by more than
7
percentage points for the year.
A second drawback to the category is price. A simple
average of the category's institutional share class
price tags looks sky-high at
0
.
99%
, but even the
group's asset-weighted levy is plenty onerous at
0
.
77%
, considering that their performance targets
are typically modest. That’s much higher than you
would pay for the typical intermediate-bond fund.
There are some funds in the group worthy of a closer
look for those who absolutely want one of this
type and understand their risks, but the value propo-
sition for the group as a whole is questionable for
investors who don’t have access to the category’s less
expensive classes. Even the best managers can't
produce miracles, and that's just about what it would
take to overcome the more than
1
.
3%
expense ratio
charged by the group's average A share fund even if
you don’t pay the load.
œ
Contact Eric Jacobson at
Tread Carefully With Non-Traditional-
Bond Funds
Income Strategist
|
Eric Jacobson
