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The unconstrained bond universe is in dire need of an image makeover. Originally envisioned as “go-anywhere,” benchmark-agnostic investment strategies, unconstrained bond funds rose to prominence between the years 2012 and 2016. During that time, many capital allocators were forecasting low forward-looking returns for US fixed income and, as such, wanted to diversify away from traditional core portfolios whose performance was tied to the Barclays US Aggregate Index (the “Agg”). Many asset managers created two types of unconstrained bond funds to meet this increased demand for non-traditional fixed income.
The first type was total-return-focused funds. However, most managers recognized that their clients were looking for these strategies to exhibit low beta (correlation) to the Agg for diversification purposes. As a result, many of the total-return strategies that were launched in the 2010s carried a significant degree of credit risk, along with low levels of duration. These strategies held up well through the “taper tantrum” of 2013, only to then perform poorly when credit spreads rose sharply in 2015 and early 2016. Having little to no duration and large amounts of credit risk caused the funds to perform roughly in line with their high-yield counterparts, rather than acting as the “anchor to windward” that most investors expect from fixed income.
The second type of unconstrained bond fund was focused on absolute return fixed income investing. Most of these strategies sought to achieve positive returns in all market settings and to have minimal beta or correlation to traditional bond market risk factors like duration and credit. Accordingly, many of them managed to perform well in “risk-off” environments like that of early 2016. However, without much in the way of market beta, many of these strategies simply did not generate sufficient returns to meet their clients’ needs and missed out on some banner years for fixed income. For example, 2014, 2019, and 2020 all saw strong fixed income market performance.
In response to their frustration with unconstrained bond funds, many clients began to employ a “barbell” strategy — allocating to both higher-yielding income funds and benchmark-relative core bond portfolios. Because income funds by definition need to offer an attractive current yield, these strategies typically featured high levels of both duration and credit. Therefore, many of them fared better in risk-off environments than unconstrained funds and benefited from yield compression when it occurred. At the same time, many allocators also wanted the equity diversification that bonds provide and, to that end, maintained…
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