Pundits have been predicting the 30+ year bull market in bonds to come crashing down for years now, but still it chugs along. Nevertheless, with coupons so low and the Fed at least murmuring about hiking rates sometime in the next six months (those murmurs got a bit louder today), it would seem that traditional fixed-income investments have a tough road ahead. For this reason, investors have been flooding into unconstrained fixed-income funds, which have a “go anywhere” approach that allows them to invest in junk bonds, emerging-market debt, senior loans, and other debentures that are typically no-nos for straight-laced bond buyers.
But while this approach has surface-level appeal, William Adams, MFS’s CIO of Global Fixed Income, and fixed-income portfolio manager Richard Hawkins think unconstrained strategies “should not be modeled as alternatives to traditional fixed income approaches.” Messrs. Adams and Hawkins articulate this view in an October 2015 white paper titled Unconstrained Fixed Income: Risks Lurking in the Shadows.
According to data from eVestment, unconstrained fixed-income hedge funds have seen their assets under management (“AUM”) grow by an annualized 29% since 2007, with AUM totaling $229 billion by 2014. The number of institutional strategies available has grown from 48 in 2007 to 118 by 2014, and the number of unconstrained fixed-income mutual funds has grown from 20 to 113 in that same time.
Messrs. Adams and Hawkins believe the rationale for these inflows is the diversification supposedly provided by unconstrained investing. But replacing traditional fixed income with unconstrained results is a tradeoff of interest rate for credit risk, and credit risk is highly correlated to equity risk. Thus, unconstrained fixed income can actually reduce the diversification benefits of portfolios that include equities.
MFS’s Adams and Hawkins take the view that duration “should not be considered the foe in the current investment environment – it just needs to be harnessed and managed appropriately.” They caution against jettisoning benchmarks (which is what unconstrained strategies do), which makes it difficult to evaluate a manager’s risk profile. A benchmark-aware approach, by contrast, provides the appropriate structure and discipline to ensure that fixed-income portfolios do what they’re supposed to do – mitigate portfolio volatility. With their high correlation to equities, unconstrained fixed-income strategies can have the opposite effect.
For more information, download a pdf copy of the white paper.