An investor’s guide to unconstrained bond funds (Part 2 of 8)

Weighing the pros and cons of unconstrained bond funds

Considering the risks and returns in fixed income investing

Before putting your money in an unconstrained bond fund (BASIX ), you should be aware of the pros and cons. As mentioned in the previous section, these are actively managed funds and don’t track a benchmark index. Besides, each fund could follow an entirely different strategy. As a result, there’s no common yardstick to compare performance. So it’s important to assess each bond fund’s benefits and disadvantages.

Unconstrained bond funds provide diversification benefits

Diversification means including different types of securities in a portfolio, with the aim of reducing portfolio risk and volatility in portfolio returns. In simple terms, don’t put all your eggs in one basket.

Unlike traditional bond ETFs such as the iShares Barclays 7-10 Year Treasury Bond ETF (IEF ), unconstrained bond funds (JSOAX) aren’t restricted to a particular geography or type of bond. These funds can invest anywhere in the world. They can have simultaneous positions in both high-yield and investment-grade bonds, government and corporate, or fixed and floating rate bonds. This gives the fund manager greater leeway in allocating funds across securities, and the potential to have multiple income streams. This flexibility helps minimize portfolio risk and maximize returns.

Diversifying credit risks

Bonds are subject to two major types of risk—credit risk and interest rate risk. Credit risk is the risk that the borrower will default on the sum borrowed. Bond prices and bond yields move in the opposite direction. Interest rate risk arises when changes in bond yields result in price changes in the fixed income security.

For example, in times of increased market volatility, investors flock to U.S. Treasuries (TLT ) because they’re lower risk. Investors also tend to shun high-yield bonds at these times. This tends to increase the price of the Treasuries and reduce the price of the high-yield bonds. An unconstrained bond fund typically has positions in both types of bonds. This potentially reduces portfolio losses.

Meanwhile, junk bonds tend to perform well in economic upturns. Their credit spread tends to narrow. This is likely to benefit prices of high-yield ETFs such as the iShares iBoxx $ High Yield Corporate Bond ETF (HYG ) and the SPDR Barclays Capital High Yield Bond ETF (JNK ).

A fund manager has the flexibility to shift between bonds of different quality. These managers can take advantage of prevailing market conditions and shift between different categories of bonds to maximize returns. This option wouldn’t be available to a conventional passively managed bond fund. Its investment choices would be limited by its stated objective and benchmark index.

In the next part, we’ll look at how unconstrained bond funds can minimize interest rate risk and why this is particularly relevant to U.S. fixed income investors right now.