How to Navigate Today's Bond Markets

Bond markets today present investors with multiple challenges, including lower yields and more risk than in the past. In this environment, unconstrained bond funds may be worth considering, explains Russ.

Bond markets today are presenting investors with multiple challenges.

Since the financial crisis, yield has become an increasingly rare commodity. Rates remain low by any historical measure thanks to years of easy money. But even if the U.S. Federal Reserve (Fed) begins raising rates this September, rates are likely to remain low for long. Other factors driving rates lower — low nominal global growth, an older population, lower fixed income supply and the disinflationary pressure of technology — will likely remain in place.

At the same time, the search for yield has sent investors flocking into riskier fixed income segments, driving up bond prices across the board. Low yields and few bargains are compounded by a separate but related problem. As yields have fallen, duration, or rate sensitivity, has risen, meaning that the risk associated with a change in rates has generally risen for most bond benchmarks and traditional funds. With higher durations, even a modest backup in yields could easily wipe out a year's worth of interest.

While the challenges cited above have been with us for several years, a new wrinkle has emerged more recently. As investor anxiety has shifted from growth and geopolitical shocks to the Fed, the correlation between stocks and bonds has started to rise, and it's likely to continue rising as a Fed rate hike nears. As a result, typical duration-heavy bond funds may not provide as effective a hedge against equity risk as they may have in the past. Adding to the challenges, volatility is likely to rise as the Fed begins to normalize monetary conditions.

In this environment, investors may need to consider less traditional approaches. One potential solution is to incorporate unconstrained bond funds. This is because, as I write in my new Market Perspectives piece, "Removing the Constraints: Understanding the Risks and Opportunities of Unconstrained Bond Funds," unconstrained funds offer the potential to mitigate some of the challenges enumerated above.

As their name implies, unconstrained funds typically contain a more heterogeneous mix of bonds than traditional bond funds heavily weighted to Treasuries. They often include instruments such as high yield, emerging market debt and other more esoteric instruments that tend to be missing from traditional bond funds. Many unconstrained bond funds also own some equity. This broader investment universe allows managers greater latitude and flexibility to search for yield, manage risk and tweak correlations, as they adopt different exposures and tactical stances.

An optimal allocation to unconstrained funds, however, would rarely be a one-for-one swap with a traditional bond fund. This is because while unconstrained funds are still primarily dedicated to fixed income instruments, they behave very differently than traditional bond funds. Depending upon the precise exposures in the funds, these instruments often have more equity-like exposures.

As such, allocation to these funds should be partly determined by an investor's allocation to other asset classes, particularly equities. In adding unconstrained, the most important concept is that portfolios with these funds will tend to have higher correlations with equities and credit.

One of the counterintuitive implications is that unconstrained funds can actually be most useful in more conservative portfolios that are dominated by traditional bonds. This is because unconstrained funds' equity and credit exposure may actually add some diversification, in addition to potential yield.

To be sure, unconstrained bond funds are no panacea. A portfolio containing an unconstrained bond fund will likely have modestly higher risk. This reflects the likelihood that the unconstrained portfolio will contain more credit and equity exposure, both of which add to the overall riskiness of a portfolio.

In addition, in a world of low yields and tight spreads, returns to these funds are also likely to be modest, at least relative to periods when yields were much higher. It's also important to note that not all unconstrained funds are the same. Moreover, given their flexible natures, they will have different exposures over time, leading to different performances over different periods.

Still, in an environment characterized by low nominal yields, often negative real yields and elongated duration, unconstrained bond funds are an alternative solution worth considering.