About five years ago, Morningstar Inc. added a new category called non-traditional bonds. The category was created to provide a classification for the large number of new funds created in the wake of financial crisis of the last decade. These bond funds give their managers latitude to invest across a wide range of global fixed-income sectors. This is in contrast to more traditional bond fund categories, such as intermediate bonds or short-term bonds, that have much narrower mandates.

Initially, many non-traditional bonds funds were designed to offer absolute returns in most markets and to protect investors from the downside risk of higher interest rates. Fast forward to today and those higher rates have not yet materialized. (For more, see: How Rising Rates Impact Bond Mutual Funds.)

An article on Morningstar.com points out that some of these funds have taken on additional types of risk in order to provide investors with decent returns. Some of these funds invest in yield debt, emerging market debt and other risky sectors. In addition, some of the funds in this category make use of derivatives as well.

Current Trends and Strategies

At a recent Morningstar investment conference held in Chicago, a panel discussion highlighted the current strategies of three non-traditional bond fund managers and some trends in this investment category. From 2008 through May of 2015 the number of funds in the category grew from 24 to 120. Assets under management (AUM) of these funds grew from about $9 billion to about $150 billion over that same time period.

Marc Schneider, who manages the PIMCO Unconstrained Bond Fund (PUBDX), targets a return of 3% to 4% above the LIBOR rate with a volatility rate of 4% to 6%. He builds the fund’s portfolio to incorporate holdings across a range of risk factors including interest rate, credit, currency, volatility and liquidity. Since its inception in 2008, the fund has beaten the Barclay’s Aggregate Bond Index only twice over a full calendar year. The fund’s five-year performance trails the benchmark by an average of 152 basis points per year for the five years ending August 23, 2016. (For more, see: Advising FAs: Explaining Bonds to a Client.)

Michael Swell, who manages the Goldman Sachs Strategic Income fund (GSZAX), said that unconstrained bond funds are not meant to replace an investor’s allocation to bonds but rather to complement their core bond allocation. He and his team strive to generate a consistent level of return with “bond-like” volatility. Swell made the point that these funds were not meant to be a product to combat rising interest rates, but rather a place where managers can invest in their best ideas to generate both income and portfolio stability. The fund has an average annual return of 2.99% for the five years ending August 23, 2016, compared to 3.24% for the benchmark.

Rick Reider, manager of the BlackRock Strategic Income Opportunities fund (BSIIX), indicated that his fund targets an annual return of 4% to 6% above the 90-day T-bill rate. The fund’s duration will fall in the range of negative two years to positive seven years. He indicated that his team’s research driven process tries build a portfolio based upon the market’s most efficient sources of risk. He stressed the changing nature of fixed income correlations and the need to consider this dynamic when building the fund’s portfolio. Through August 23, 2016, the fund has gained an average of 3.63% annually versus 3.24% for the Barclay’s Aggregate. (For more, see: (For more, see: Investing in Alternative Mutual Funds and ETFs.)

Other Key Points

The Morningstar panelists made a few other points about non-traditional bond funds:

  • Since 2008 the shift in focus among many of these funds has moved from generating additional income to taking a more absolute return approach designed to limit volatility for investors.
  • The panelists also indicated that they are focused on reducing risk in their funds to help cope with what they perceive to be a period of increasing volatility and uncertainty in the financial markets.
  • They feel that the flexibility of their investing mandates provides them with the ability to meet the challenges investor will face in the coming years.

Bond Fund or Alternative?

The Morningstar Advisor site has a tool called the Alternative Fund Quick Rank which lists 264 liquid alternative funds. Non-traditional bond funds are a fund category that is included in this screener. Given many of the comments of the Morningstar panelists and others I would agree that these funds belong more in the alternatives camp than the fixed-income camp when financial advisors look to use them as a tool in client portfolios. They seem to be liquid alternatives using fixed income as their underlying investment tool.

For example, the BlackRock fund has a beta of 0.20 compared to the Barclay’s Aggregate Index and the non-traditional bond category has a beta of 0.12% for the five years ended July 31, 2016. A beta of 1 would indicate that the fund moves in lockstep with the benchmark.

The Bottom Line

Non-traditional bond funds grew out of the 2008 financial crisis. They may or may not actually be bond funds based on your point of view. The low correlations that many of these funds have to the Barclay’s Aggregate can make them a solid choice for client portfolios. As with anything else, financial advisors need to look hard at any fund in this category that they may be considering. (For more, see: Alternative Investments: A Look at the Pros & Cons.)