(PUB) Morningstar FundInvestor

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Tread Carefully With Non-Traditional- Bond Funds Income Strategist | Eric Jacobson

Most funds in the category can build very large expo- sures to junk bonds, emerging-markets debt, and even foreign currencies, and most are taking on credit risk of one kind or another. The average intermediate-term bond offering has around an 11% exposure to below- investment-grade bonds, while the average nontradi- tional fund carries more than 3 times that amount with an average 36% weighting. The market hasn't endured a sustained sell-off among credit-sensitive bonds since the 2008 financial crisis, however, so most funds that have sprouted up in recent years haven't been tested by much adver- sity in the credit markets. If there is a useful period to examine, though, it's 2011 . Europe's banking crisis spread panic around the world during that year's third quarter, investors dumped most credit-sensitive debt, and money flooded into U.S. Treasury bonds. Funds that had stripped out most of their interest-rate sensitivity therefore saw double trouble. Their riskier assets fell in price, yet they didn't have the insurance that sensitivity to U.S. rates otherwise provided to core funds. As such, the average intermediate-term fund outpaced the average nontraditional offering by more than 7 percentage points for the year. A second drawback to the category is price. A simple average of the category's institutional share class price tags looks sky-high at 0 . 99% , but even the group's asset-weighted levy is plenty onerous at 0 . 77% , considering that their performance targets are typically modest. That’s much higher than you would pay for the typical intermediate-bond fund. There are some funds in the group worthy of a closer look for those who absolutely want one of this type and understand their risks, but the value propo- sition for the group as a whole is questionable for investors who don’t have access to the category’s less expensive classes. Even the best managers can't produce miracles, and that's just about what it would take to overcome the more than 1 . 3% expense ratio charged by the group's average A share fund even if you don’t pay the load. œ Contact Eric Jacobson at eric.jacobson@morningstar.com

Bond yields confounded investors in early 2014 by mostly falling at a time when so many were expecting them to rise. Not surprisingly, fund investors turned to nontraditional bonds for help. The category saw more than $50 billion of inflows in 2013 and another $19 billion during the first five months of 2014 . The trend has been fueled mostly by investors' con- tinuing fear of rising yields, and much of the money going into the category has been reported to be coming out of core bond funds, most of which reside in the intermediate-term bond Morningstar Category and are benchmarked to the Barclays U.S. Aggregate, the bond market's version of the S & P 500 . Most non-traditional-bond funds are sold on the premise that investors can protect themselves from rising yields by giving managers broad flexibility to manage interest-rate sensitivity—in contrast to core funds that keep their rate sensitivities in range of their benchmarks—yet still earn returns competitive with those expected of core funds. Most managers in the category haven't made dramatic interest-rate bets, though, and in fact have kept their durations (a measure of interest-rate sensitivity) relatively short in recent years; most recently the category median was around 1 . 6 years, while the average intermediate-term bond fund clocked in around five years in May 2014 . There's a natural conflict, however, between trying to mitigate interest-rate volatility by keeping a fund's duration short and still generating returns competitive with those of intermediate-duration funds. When interest rates aren’t surging, the only way to make that happen is to take other risks to compensate for the return potential lost by keeping a fund's rate sensitivity low for a long time.