(PUB) Investing 2016

20

Non-Traditional-Bond Funds Can Pack Plenty of Credit Risk Income Strategist | Eric Jacobson

in below-investment-grade and nonrated bonds, the mean non-traditional-bond fund has roughly 44% in lower-quality debt, which is nearly on par with the credit-sensitive multisector-bond norm. One notable exception is FPA New Income FPNIX , which won’t invest more than 25% in bonds rated below A-. Meanwhile, most non-traditional-bond funds’ compositions can vary widely across corporate, sovereign, and structured credit; cash bonds; and derivatives, each of which is subject to different factors driving performance. Still, the overall trend is clear: As non-traditional-bond funds have dialed down interest-rate risk, they’ve dialed up others that present their own set of concerns. Another common theme in the category is the liberal use of derivatives. Generally speaking, it’s easier to add or reduce market exposures with derivatives such as swaps and futures without having to tie up as much capital as would be required when trading cash bonds. Moreover, as tightening regulations follow- ing the financial crisis have made it costly for banks to keep bonds on their balance sheets, liquidity among cash bonds has eroded even further compared with most derivatives. That has made the latter an enticing tool for managers seeking positive absolute returns without broad, systematic market risks. In theory, one can insulate a portfolio of bonds from interest-rate volatility with swaps or futures. Similarly, one can take on credit expo- sure to specific names while theoretically insulating a portfolio from broad market-risk by using credit default swaps. Many funds in the category include global currencies and far-flung credit markets in their tool kits, and both can be difficult (or impossible) to develop without derivatives. Given their complexities, knowing and understanding the underlying exposures in a non-traditional-bond fund can be daunting. It’s as or more important in this category, though, than almost any other. This is why so few funds in the group are Morningstar Medalists. K Contact Eric Jacobson at eric.jacobson@morningstar.com

We launched our non-traditional-bond Morningstar Category nearly five years ago to create a more useful classification for a deluge of new funds following the financial crisis. Most gave active bond managers a wide degree of latitude to invest across the globe. Many also promised an attractive absolute return stream uncorrelated to traditional markets but are often positioned as substitutes to traditional core bond funds and to protect investors from the risk of rising rates. While funds in the category are touted for their flexi- bility, many have simply exchanged interest-rate risk for some other. Many feature sizable stakes in high-yield, emerging-markets debt, or other “risk” sectors, and tend to use derivatives more heavily than more-traditional fixed-income offerings. Most non-traditional-bond funds have exhibited rela- tively low interest-rate sensitivity, with average durations between one and two years. That’s much shorter than the intermediate-term bond category norm of around five years, roughly comparable to that of the Barclays U.S. Aggregate Bond Index. While some funds have kept rate sensitivity consis- tently low, others have shifted their durations up and down in big moves depending on their managers’ views. Since mid- 2011 , there have been periods when the longest 10% of the group have stretched beyond 5 . 1 years, while the shortest 10% have gone shorter than negative 1 . 5 years. Most of that activity stays below the market’s overall duration as these funds have been sold as protections against rising rates. While minimizing interest-rate risk, though, non- traditional-bond funds have loaded on credit risk in order to produce decent yields. Whereas the typical intermediate-bond fund holds around 10%