Can unconstrained bond funds help investors mitigate interest rate risk?

EARLIER this week, after the G-7 finance ministers' meeting in London, US Treasury Secretary Janet Yellen stated that a slightly higher interest rate environment "would actually be a plus for society's point of view and the Federal Reserve's point of view". While the debate around inflation and its benefits rages on, the prospect of rising rates leaves fixed-income investors in a difficult position, exposing them to interest rate risk.

In such an environment, traditional fixed-income portfolios may no longer be able to achieve the goals of stable income and low risk to principal. How then should investors position their portfolios appropriately?

Interest rate risk and potential workarounds

Interest rate risk is the probability of losses in fixed-income assets, associated with movements in interest rates. Sensitivity to interest rates is affected by duration, which can be thought of simply as the weighted average of the time required to receive fixed cash flows from a financial asset.

For the same yield, fixed-income investors typically face a trade-off between undertaking duration and credit risk. Investors in safer fixed income segments, such as US Treasuries, usually have to invest in longer maturities in the search for yield, exposing themselves to higher interest rate risks.

Some investors seek to reduce interest rate risk by investing in shorter duration but higher-yielding products, such as high-yield bonds. They typically exhibit lower duration, but investors are exposed to greater credit risk as the probability of default or rating downgrades is higher.

However, there is not much value left in high-yield bonds, considering that credit spreads for the segment have compressed significantly near the 10-year lows. This limits the potential upside as there is little room for further spread compression.

High-yield bonds are also a poor diversifier of market risk. Among the various fixed-income segments, they tend to be most correlated to equity markets, especially during periods of financial stress. For example, global high yield and global equity had a near-perfect one-year correlation of 0.9 during the March 2020 pandemic sell-off.

All in all, investors will find it tough to generate decent yields without taking on more risks. Therefore, investors should look towards unconstrained bond funds, which we believe are designed to better navigate the current fixed-income environment.

Another string to investors' bows?

Unconstrained bond funds emerged in the wake of the 2008 financial crisis, as fund managers expected the Fed to increase rates after a strong economic recovery. They were created on the rationale that reducing constraints on portfolio managers enables them to take advantage of market mispricings and aggressively manage their duration profile.

Unconstrained bond funds have attracted increased attention in recent times as they seek to provide positive returns regardless of the direction of interest rates and market conditions.

Typically, these funds have the following characteristics:

• Flexible duration: Unconstrained bond strategies are typically constructed with a flexible duration profile in mind. They can be adjusted based on prevailing market conditions, potentially even exhibiting zero or negative duration in some situations.
• Use of derivatives and short positions: While these are mainly used to manage duration, they can also be used to express views on credit spreads and volatility. Derivatives and short positions also allow fund managers to implement a currency overlay on their fund based on their view, which can be another source of return. These are only a few examples out of a myriad of possibilities of how the risk-return characteristics of a fund can be modified.
• Broader investment universe: Funds with unconstrained strategies can invest across the spectrum of fixed-income assets from Treasuries to high yields, and are typically not limited by geography. They may also invest in asset-backed securities.

Resilience

Thus far, these funds have generally done well amid the inflation and tapering scares that have typified much of the last quarter. As Treasury yields rose, unconstrained bond funds stood relatively resilient as global bonds fell. This is perhaps a textbook example of how unconstrained bond funds can help investors manage interest rate risk.

While managing interest rate risk is key in the current economic climate, unconstrained bond funds come with their own unique set of risks. The lack of benchmark and increased flexibility in mandate expose investors to a new type of risk: managerial risk. Essentially, investors are reliant on the manager's ability to get his calls right, and investors must consider the manager's track record and experience when it comes to fund selection.

In addition, active management strategies typically lead to higher turnover for the fund's assets, and this could lead to higher expenses in terms of trading costs and research. With bond yields already so tight, investors can scarcely afford to give up further returns in the form of fees, and should monitor the fund's expense ratios as well.

Should you add unconstrained bond funds to your portfolio?

While the global macro environment is more conducive for risk-on assets such as equities and high-yield bonds, high-quality fixed-income assets have historically had a key role to play in investors' portfolios, and will likely continue to do so.

Unconstrained bond funds provide investors with another string to their bow in their bond allocation decision, and importantly, one that is more adaptable to the interest rate environment.

Among unconstrained bond funds, investors may consider the Allianz Global Opportunistic Bond Fund or the BlackRock Fixed Income Global Opportunities Fund. Both have shown resilience to interest rate risk, and are backed by experienced management teams.

• The writer is the unit trust analyst of the research & portfolio management team at FSMOne.com. FSMOne.com is the B2C division of iFAST Financial Pte Ltd, the Singapore subsidiary of SGX Mainboard-listed iFAST Corporation Ltd.