The three hallmarks of an unconstrained bond fund

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2023-12-31
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The next economic cycle is probably going to look very different than the last one. First, it could be one in which the historically negative correlation between equity market and government bond returns is less pronounced. Second, credit volatility is likely to be elevated and liquidity crises more frequent.

As discussed in our 2021 white paper, Are we on the cusp of an unconstrained bond fund “renaissance”?, it is precisely in this type of environment that we think unconstrained bond funds can play a valuable role in an allocator’s fixed income portfolio. The chief aim of such a strategy is to generate consistent risk-adjusted returns across varying market conditions, while still retaining fixed income’s traditional diversification benefits.

We believe an unconstrained fixed income strategy should incorporate three key characteristics:

1. Dynamic approach

A truly unconstrained manager should seek to access the full toolkit of unique market betas, security selection, duration management, liquidity, relative-value trades, world currencies, and credit exposures available in the global markets to help adapt the portfolio to a prospective range of macroeconomic environments. Ideally, in constructing the portfolio, the manager should have no structural bias to any particular market sectors or investment disciplines.

Growth and inflation are of course critical drivers of long-term asset returns, as the combination of these two factors helps determine which assets are best placed to outperform in different economic regimes. An unconstrained manager must be able to move with ease among all four quadrants of the growth/inflation matrix shown in Figure 1 (with each quadrant corresponding to a particular economic regime). This ability to be flexible and dynamic looms even larger in the current cycle, which is likely to be marked by greater global macroeconomic variability and asset-price volatility than the last cycle.

Figure 1
The three hallmarks of an unconstrained bond fund

For similar reasons, credit market volatility may also be higher in the period ahead. While many allocators properly observed the credit opportunities that arose amid the market disruptions of March 2020, many fixed income managers’ ability to move capital swiftly to capture the market mis-pricings was severely hampered by poor liquidity conditions. In such situations, unconstrained bond funds can act as the de facto “tactical asset allocator” for clients who may not otherwise be able to reallocate capital quickly and nimbly in response.

2. Benchmark-agnostic

To take full advantage of an unconstrained bond universe and truly diversify a client’s fixed income allocation, a manager must be able to access and evaluate a wide range of securities. By basing investment decisions on specific total-return opportunities instead of in relation to a benchmark, the manager is more likely to provide additional exposures not often held in client portfolios, including non-core asset classes that are “off the radar” of most investors. This greater variety of fixed income opportunities as compared to traditional benchmark-centric strategies typically translates to greater overall portfolio diversification.

Naturally, an unconstrained bond fund will tend to have higher realized tracking risk (TR) against the broad market indices than most traditional core strategies. Investors accustomed to gauging their fixed income allocations partly by adherence to preestablished TR ranges may initially find these higher TR levels to be unsettling. However, “unconstrained” does not have to mean “high risk,” despite the potential inclusion of a wide array of noncore positions. An unconstrained strategy encourages commonly sought-after investor outcomes (rather than benchmark-oriented investing), including capital preservation via multiple downside mitigation agents working in concert. In fact, we contend that higher TR can make an unconstrained approach a better complement to traditional fixed income strategies as a portfolio diversifier, while also enhancing total-return potential.

3. Absolute return “hybrid”

Most unconstrained bond strategies followed two distinctly different routes back when the fund universe was first created — toward either total-return or absolute return investing. This was a false dichotomy, in our view, because we believe unconstrained bond funds should seek to offer the best of both worlds.

Investors need exposure to longer-term strategic themes that have some degree of market beta in order to generate returns when yields are compressing. At the same time, absolute return strategies can serve an important purpose in minimizing portfolio downside during higher-volatility periods. Having both capabilities in one fund gives a manager increased flexibility as a macro cycle progresses. Earlier in the cycle, when yields and spreads are high, the manager can allocate more to strategic fixed income sectors and away from absolute return. Later in the cycle, when beta opportunities may be scarce, the manager can allocate away from strategic sectors in favor of absolute return.

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