These Bond Funds Might Offer Juicy Yields, and Unwelcome Surprises

Investing in a so-called unconstrained bond fund is like that team-building exercise where you fall backward into someone’s arms: It can work, but it requires a lot of trust.

These funds prospect far more widely for their holdings than a typical core bond offering that might anchor a portfolio. They usually can buy bonds regardless of credit quality or country of issue. Often, they can also scoop up currencies, derivative and convertible securities, and even stock.

Their flexibility means they have the potential to give higher returns than funds owning just U.S. Treasuries and investment-grade corporate bonds. But the unconstrained funds’ complexity can make their risks hard for less-sophisticated investors to unravel.

And that can invite unwelcome surprises, especially in times of market tumult. In the first quarter of 2020, when the stock market sank as the pandemic raged, the unconstrained bond funds tracked by Morningstar, the investment analysis company, lost an average of 7.6 percent. The funds returned an average of 3.54 percent in the fourth quarter. By contrast, consider the iShares Core U.S. Aggregate Bond Exchange-Traded Fund, which invests in U.S. government and investment-grade bonds and tracks the benchmark Bloomberg Barclays U.S. Aggregate Bond Index. The fund returned 3.06 percent in the first quarter and 0.73 percent in the fourth quarter.

Longer term, the average unconstrained fund has fared somewhat better, giving an annual average total return of 2.86 percent over the last decade, compared with 3.76 percent for the iShares fund.

Lately, the lure of unconstrained funds is their yield: In a world awash in measly interest rates, they can offer more income than more traditional bond funds.

As of Dec. 31, the average trailing 12-month yield of unconstrained funds was 3.19 percent, while the iShares fund paid 2.17 percent.

But a richer yield can come at a cost of confusion.

“When you’re buying an unconstrained fund, you really don’t know what you’re getting unless you look carefully at the portfolio and read the analyst reports,” said Steve Kane, co-manager of the TCW Metropolitan West Unconstrained Bond Fund. “You could be buying a global macrofund invested in currencies or a high-yield-bond fund in disguise.”

That sort of elusiveness characterizes even Mr. Kane’s fund. “There’s very little we can’t do,” he said. Yet he said he and his co-managers avoid bets on currencies, stock or convertibles because they believe they’re better at picking bonds.

Their portfolio consists mainly of corporate and mortgage bonds and asset-backed securities. Asset-backed securities are pools of assets, like credit card receivables or auto loans, that are securitized as bonds.

The retail shares of the fund have an annualized average return of 5.2 percent since 2011, the year of the fund’s inception.

Given how low current interest rates are — the 10-year Treasury is paying about 1 percent — Annie McCauley, a senior vice president at the Sequoia Financial Group in Akron, Ohio, called unconstrained funds “a solid maybe” for retail investors.

A juicier yield alone shouldn’t tempt people to invest in something they don’t understand, she said.

“You can’t have higher income and not also have a trade-off to get that,” she said. “You have to recognize that the downside of an unconstrained fund could look more like an equity fund than a bond fund,” she said.

One way to gain a sense of the typical zigzags of a fund’s returns is to check its monthly numbers, she said. Investors will sometimes fixate on longer-term measures, like three- and five-year returns, but those can smooth out monthly jumps and dives.

Managers of unconstrained funds acknowledge that their offerings’ greater income can stem partly from buying riskier fare, such as high-yield and emerging-markets bonds. But they also say their broad baskets of bets can help damp risk.

“People view ‘unconstrained’ as meaning we can hang from the chandeliers,” said Rick Rieder, lead manager of the BlackRock Strategic Income Opportunities Fund. “What it really means is we can use a number of tools to reduce risk. We’re trying to make a little bit of money all of the time and not put all of our eggs in a one basket.”

Recently, Mr. Rieder’s fund included investments in high-yield and emerging-market bonds, residential and commercial mortgage securities, Treasuries, derivatives and collateralized loan obligations. (C.L.O.s are groups of loans, often corporate loans or ones used to fund buyouts, that are pooled and securitized.)

By at least one measure, that motley mix did produce a fund less jittery than its peers: The standard deviation of its returns was 5.15 percent, compared with 6.47 percent for the average unconstrained fund tracked by Morningstar. A lower number indicates less volatility.

Mr. Rieder’s fund has an average annual return of 3.52 percent over the last decade.

The varied holdings of an unconstrained fund may also help reduce the overall riskiness of a person’s portfolio, complementing core bond holdings, said Marc P. Seidner, lead manager of the PIMCO Dynamic Bond Fund.

That’s because the fund’s investments won’t necessarily be correlated with the level and direction of U.S. interest rates, which determine the return of typical bond funds, he said.

So an unconstrained fund may help protect against rising interest rates, he said. (Bond prices fall when rates rise.)

Higher rates may seem unlikely at the moment, with the coronavirus weighing on the economy. But once people are vaccinated, they’ll travel, dine out and shop in brick-and-mortar stores again.

“If you look at our portfolio, there’s an element of it that has Covid recovery built in, like convertibles issued by cruise lines and airlines, hotels, and some retailers,” Mr. Seidner said. The fund’s investments recently included convertibles issued by Royal Caribbean Cruises and Southwest Airlines, as well as bonds issued by the Carnival Corporation, a cruise line, and Delta Air Lines.

The PIMCO fund has returned an annual average of 3.76 percent since its inception in 2008.

If you opt to buy into an unconstrained fund, determining the risks it’s taking is critical, said Karin Anderson, director of fixed income manager research for Morningstar. Doing so can also be very challenging.

“It can be hard for an individual investor to parse what’s going on,” she said. “Half of the holdings might be derivatives, and you wouldn’t know what was hedging what or what they were giving you exposure to.”

Unconstrained funds often aren’t benchmarked against well-known broad-market bond indexes; sometimes they’re not benchmarked at all. So rather than just assessing how a fund fared against a common yardstick like the Bloomberg Barclays U.S. Aggregate Bond Index, you may also want to compare it either to peers or borrow a benchmark from another asset class.

“If a fund’s heavy in high-yield bonds, it’s fair to see if it beats a traditional high-yield index,” Ms. Anderson said.

Assessing fees is essential, too, as unconstrained funds can be expensive, she said. High fees erode returns; Morningstar has found that they predict poor fund performance.

The average unconstrained fund has a net expense ratio of 1.2 percent, while the average intermediate core bond fund — one invested in Treasuries and investment-grade corporate debt — has an average expense ratio of 0.79 percent, according to Morningstar.

Finally, you have to ensure that a fund manager’s goals are aligned with yours and understand the trade-offs you’re accepting with that person’s strategy, said Arif Husain, manager of the T. Rowe Price Dynamic Global Bond Fund.

“If someone promises you a high level of income, there will be higher volatility and higher correlation with the stock market. If someone promises you diversification, the trade-off is lower levels of income. In my experience, there’s no such thing as a high-income diversifying strategy.”


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