The 10th Man: I Had My Cake, Until I Ate It

After 30 years of declining interest rates, bond investors are beginning to worry that rates will go higher—especially after the events of May 2013.Back then, 10-year yields went from 2% to 3% on a frozen rope. Things got very dicey in fixed income. Some holders of corporate bonds (like the new Apple bond) were suddenly down 10% just on interest rates alone.So worrying about rising rates is not unreasonable. People learned very quickly how duration works, after having forgotten for decades. If you’ve never taken a bond math class, all you need to know about duration is this:

1. It is the weighted average time to maturity of all coupon and principal payments.
2. It is an approximate measure of interest rate risk.

With regard to 2), if the duration of a 10-year Treasury note is 8.5 years, for every 1% change in interest rates, the price of the bond will change by approximately 8.5%.

A 1% change in interest rates doesn’t sound like a lot, but an 8.5% hit to your capital if you’re a bond investor sounds terrible.

After 2013, people were looking for ways to mitigate interest rate risk and yet hang on to their bond portfolios. That is hard to achieve, because, well… bonds have interest rate risk!

Unconstrained Bond Funds

So this is the Holy Grail of bond investing: how to create a durationless portfolio that still has a return. People are doing it, with mixed success.

A few years back, people started investing in what were known as “unconstrained bond funds.” As the name implies, an unconstrained bond fund isn’t restricted to a sector or strategy or even a country. Unconstrained bond funds can invest in corporate credit, sovereign credit, currencies, high yield, emerging markets, any and all derivatives, and of course, Treasuries. They can invest in just about anything in any allocation.

Unconstrained bond funds have been known to move very quickly in and out of certain credits, even holding over 50% cash at times. The manager has broad discretion to change his asset allocation to maximize returns and more important, to dodge rising rates.

Unconstrained funds have become very popular. Unsurprisingly, money moved out of core bond funds in 2013 (after people got whacked on rates) and into unconstrained funds, which theoretically shield you from higher rates. Maybe.

That depends largely on the manager. In the old days of bond investing, you would pick a bond fund with a narrowly defined mandate, like “medium-term corporates,” and the bond manager would spend his life trying to outperform the stated benchmark.

For a core bond fund, the typical benchmark is the Barclays (formerly Lehman) Aggregate Index. This index is very heavy on government bonds and mortgages, and in a world of potentially rising rates, nobody wants to be tied to the “Agg,” as it is known.

In an unconstrained bond fund, the manager can hedge interest rate risk with futures, options, or swaps, or even short Treasury bonds or notes, and make up the loss in yield by overweighting credit. In fact, this is what many of them do. Of course, this all comes at a time when credit is very overpriced and there are even more concerns about the valuation (and liquidity) of corporate bonds.

There’s also the idea that the whole point of investing in a bond fund is to diversify away equity risk—bond funds usually do well when stock funds are doing poorly. But high yield actually has equity-like characteristics, so if you’re immunizing the duration and loading up on credit, you are doubling down on your risk profile.

Market-Timing Your Way to Victory

I think it’s kind of interesting that investors are giving so much latitude to the managers of unconstrained bond funds. What they are doing, in essence, is market-timing, something that is generally frowned upon when done by amateurs.

Some people will do it well, but most people will do it poorly. It is very hard to evaluate one unconstrained bond fund against another because you can’t even look at the portfolio on a static basis and judge it on its investment merits. You’re betting purely on the skill of the manager. It’s like betting on jai-alai. The players probably have a better idea of who’s going to win than you do.

In general, the unconstrained bond funds haven’t been doing all that great. If they’ve outperformed core funds, it hasn’t been by much. But they haven’t yet been tested by a rising rate environment. These guys might find that their hedges don’t work in the way that they planned or, at worst, give the portfolio return characteristics that mimic equity funds and other asset classes.

It’s no fun when everything you own goes down at the same time.

You occasionally see these situations in finance, where people want to have their cake and eat it, too. There are dozens of examples, but the classic one is portfolio insurance, where people want to cut risk without cutting the actual portfolio—pretty similar to what’s going on here with bonds.

There probably aren’t any systemic consequences to the proliferation of unconstrained bond funds, except a continuation of the credit bubble and maybe a lot of unhappy investors. If you reduce risk over here, you’re going to end up adding it over there—at least, if you want to achieve the same or greater return. There is no way around it.

At least it’s fun for the managers. I’d much rather be swinging it around with FX and derivatives than trying to beat the medium-term corporate bond index by a couple of basis points.

Plus, the fees are higher.

Corrections/Amplifications: Last week in our discussion about gold, I implied that Barry Ritholtz, CIO of Ritholtz Wealth Management, was permanently bearish on gold. That is actually untrue: Barry was long gold for an extended period of time, starting in 2005, which I was not aware of. His objection to gold has less to do with gold itself and more to do with people’s lack of discipline and risk management with regard to the asset class. My apologies to Mr. Ritholtz.

Jared Dillian