(PUB) Investing 2016

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We launched our non-traditional-bond Morningstar
Category nearly five years ago to create a more useful
classification for a deluge of new funds following
the financial crisis. Most gave active bond managers
a wide degree of latitude to invest across the globe.
Many also promised an attractive absolute return
stream uncorrelated to traditional markets but are
often positioned as substitutes to traditional core
bond funds and to protect investors from the risk of
rising rates.
While funds in the category are touted for their flexi-
bility, many have simply exchanged interest-rate
risk for some other. Many feature sizable stakes in
high-yield, emerging-markets debt, or other “risk”
sectors, and tend to use derivatives more heavily than
more-traditional fixed-income offerings.
Most non-traditional-bond funds have exhibited rela-
tively low interest-rate sensitivity, with average
durations between one and two years. That’s much
shorter than the intermediate-term bond category
norm of around five years, roughly comparable to that
of the Barclays U.S. Aggregate Bond Index.
While some funds have kept rate sensitivity consis-
tently low, others have shifted their durations up and
down in big moves depending on their managers’
views. Since mid-2011, there have been periods when
the longest 10% of the group have stretched beyond
5 .1 years, while the shortest 10% have gone shorter
than negative 1.5 years. Most of that activity stays
below the market’s overall duration as these funds
have been sold as protections against rising rates.
While minimizing interest-rate risk, though, non-
traditional-bond funds have loaded on credit risk in
order to produce decent yields. Whereas the
typical intermediate-bond fund holds around 10%
in below-investment-grade and nonrated bonds, the
mean non-traditional-bond fund has roughly 44%
in lower-quality debt, which is nearly on par with the
credit-sensitive multisector-bond norm.
One notable exception is FPA New Income FPNIX,
which won’t invest more than 25% in bonds rated
below A-. Meanwhile, most non-traditional-bond
funds’ compositions can vary widely across corporate,
sovereign, and structured credit; cash bonds; and
derivatives, each of which is subject to different
factors driving performance. Still, the overall trend is
clear: As non-traditional-bond funds have dialed
down interest-rate risk, they’ve dialed up others that
present their own set of concerns.
Another common theme in the category is the liberal
use of derivatives. Generally speaking, it’s easier to
add or reduce market exposures with derivatives such
as swaps and futures without having to tie up as
much capital as would be required when trading cash
bonds. Moreover, as tightening regulations follow-
ing the financial crisis have made it costly for banks to
keep bonds on their balance sheets, liquidity among
cash bonds has eroded even further compared with
most derivatives.
That has made the latter an enticing tool for managers
seeking positive absolute returns without broad,
systematic market risks. In theory, one can insulate a
portfolio of bonds from interest-rate volatility with
swaps or futures. Similarly, one can take on credit expo-
sure to specific names while theoretically insulating
a portfolio from broad market-risk by using credit default
swaps. Many funds in the category include global
currencies and far-flung credit markets in their tool kits,
and both can be difficult (or impossible) to develop
without derivatives.
Given their complexities, knowing and understanding
the underlying exposures in a non-traditional-bond
fund can be daunting. It’s as or more important in this
category, though, than almost any other. This is why
so few funds in the group are Morningstar Medalists. K
Contact Eric Jacobson at
Non-Traditional-Bond Funds Can
Pack Plenty of Credit Risk
Income Strategist | Eric Jacobson