When bond funds think outside the box

UNCONSTRAINED bond funds can own debt instruments of any type - long or short-term, high or low-quality, corporate or government or whatever, in any country and currency - to try to enhance returns. With interest rates near record lows and investors eager to bolster yields, enthusiasm for these portfolios, also known as non-traditional funds, seems boundless, too.

The level of assets in non-traditional bond funds tracked by Morningstar rose about 80 per cent last year, to US$123 billion. They continued to attract fresh money early this year, reaching US$132 billion in assets at the end of February. How richly have shareholders been rewarded for these funds' ability to go anywhere in search of the best performance? Not very. The average non-traditional bond fund returned 0.3 per cent last year and 1.1 per cent in the first quarter of 2014.

Unconstrained can mean unprofitable, it turns out, and it can mean riskier, too, versus conventional bond funds, investment advisers warn. While the freedom to hold any type of bond can make unconstrained funds valuable portfolio additions, it's essential to use the freedom wisely, they say. Some managers may be taking on too much risk to satisfy investors who are fed up with the low income of many bonds.