Unconstrained bond investing

Therefore, it's an asset class whose real potential leans on fund managers' ability to make tactical moves on asset allocation by swiftly reacting to market movements.

Due to the lack of a performance benchmark, unconstrained investing seeks to generate absolute positive returns by taking both positive and negative bets on fixed-income instruments.

Greg Nott, chief investment officer at Russell Investments Canada, says the strategy works best as a complement to a core fixed-income holding.

"The inclusion of an unconstrained approach as a component of the fixed-income allocation should reduce overall portfolio risk," he says. "The relatively low duration, high flexibility and broad alpha sources [which provide risk-adjusted returns] of an unconstrained fixed-income strategy can be expected to deliver returns that are lowly correlated to other fixed-income sectors and equity markets."

However, this comes with a degree of complexity. For one, these funds invest heavily in higher yielding corporate debt, which exposes them to corporate credit risks such as defaults and widening of credit spreads -- the differences between corporate and government bond yields.

Further, many of these go-anywhere bond funds load up on complicated derivatives and lower-rated corporate bonds that tend to perform more like stocks than bonds.

The strategy requires managers to frequently reposition their portfolios by switching between different types of instruments. This leaves many unitholders unaware of their portfolio's risk profile and, typically, with higher fees than regular bonds funds.

Managers of non-traditional bond funds say the ultimate goal is to maximize total investment return.

"Since this is an absolute return product, the objective is to generate a positive real return over a market cycle, regardless of the direction of interest rates or credit spreads," says Nott.

Michael Hasenstab, Franklin Templeton

The risks, it's argued, are adequately compensated by a broader opportunity set.

"The strategy should be viewed as investing in the best opportunities in bond markets around the world without being limited to the parameters of a traditional benchmark," says Michael Hasenstab, chief investment officer, global bonds for Franklin Templeton Fixed Income Group and portfolio manager of Templeton Global Bond  . "The goal is to find medium- to long-term investment value across currency, interest-rate markets and sovereign credits, thus allowing the fund to navigate various economic environments."

As for the brisk rebalancing of portfolios, Nott says managers with broad investment skills and insight "ensure that only their best ideas are represented in the portfolio."

Hasenstab cautions that investors should be taking a longer-term perspective when evaluating the success of this strategy.

"The strategy has the ability to move quickly but it does not attempt to trade or market-time short-term volatility," he says. "Rather, the strategy is driven by long-term investing objectives and fundamental analysis."

Nott says the approach is particularly suitable for the current environment and for meeting the challenges of rising interest rate.

"Now is a particularly attractive time to consider adding this type of strategy, with bond yields falling so far in 2014 back to extremely low levels," says Nott. "They are much more likely to rise than fall further over the coming 12 months. An unconstrained strategy could protect or even profit from a rise in bond yields."

Managers achieve this by lowering the average duration of the fund. The bond with a lower duration will be less negatively affected by rising yields.

Investors and fund managers must also keep an eye on overall portfolio volatility, which tends to spike when a fund invests in more volatile and less liquid markets.

It depends on a manager's skill to reduce volatility, says Boston-based Daniel S. Janis, senior portfolio manager at Manulife Asset Management who manages Manulife Strategic Income  .

"One way we contain volatility is by not having any single credit position -- whether it be high yield, emerging market debt or high-grade credit -- greater than 1.5%," he says. "Having that position size ensures liquidity. We never hold so much that we should not get liquidity."

Daniel S. Janis, Manulife Asset Management

The flexible investing approach also necessitates the use of derivatives -- risk-mitigating instruments such as futures contracts, forward contracts, options and swaps -- to hedge out risks like rising interest rates or weakening currencies.

That's one of the reasons Sue McNamara, vice president, fixed income at Beutel, Goodman & Co. Ltd., is not sold on the strategy.

"Efforts to mitigate interest rate risk of core bond funds using 'exotic' bond instruments such as swaps, futures, forwards and credit default swaps (CDS) leave the investor susceptible to counterparty risks," she says. "Those instruments are opaque and aren't suitable for our core fixed-income strategies."

The risk, particularly with CDS, is that the counterparty may not be solvent to pay when required. "Following the credit crisis, governments have vowed no more financial institution bailouts," argues McNamara. "So a massive derivatives counterpart will not be rescued going forward."

Janis says there are measures that guard against the counterparty risk.

"Derivatives that we use -- forward contracts such as foreign exchange forwards or options, interest rates futures -- are very simple and liquid instruments," he says. "We have corporate oversight in terms of what counterparty we can utilize. They have to meet a minimum rating requirement."

Then there's the cost risk. That is, the cost of maintaining the insurance relative to the potential benefit of loss protection. "As interest rates decline, or go sideways like they have so far this year, the cost to maintain the insurance is still incurred," says McNamara. "Additionally, as interest rates start to increase, the cost to maintain the insurance will also likely increase."

Janis says he also keeps most of his forward exposure and foreign exchange less than three months "so as not to bear that interest rate risk of a forward contract."

Nott reminds that even though the strategy is unconstrained, it has investment parameters.

"The degree of currency exposure is broad, but [for his fund] limited to approximately 20% of the pool," says Nott. "There are also some constraints on credit exposures. High-yield exposure, for instance, could range between -10% to +20%."

There are additional regulatory restrictions around the use of counter-parties and illiquid securities which must be followed, he adds.

As an absolute return strategy, allocating a portion of one's fixed-income portfolio to opportunistic, benchmark-agnostic bond funds does have some merit, but investor expectations must be tempered with such constraints as limited history, scarce data and high management fees.

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