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Unconstrained Bond Funds: A Closer Look Unconstrained bond funds can pose unique challenges for measuring and understanding performance.
BY Hong Xie

In the aftermath of the global financial crisis of 2007-2008, one noticeable trend in fixed income investment is the growth and popularity of unconstrained bond funds. These funds have generated strong interest in the investment community due to their unique mandate and the opaque nature of the investment strategies associated with them. Because they are not managed against a specific benchmark, unconstrained bond funds can also pose potential challenges for measuring and understanding their performance. In this paper, we provide an overview of unconstrained bond funds, assess their past performance, and analyze the investment strategies associated with them.

EXECUTIVE SUMMARY

>• An unconstrained bond fund can invest in a wide range of debt instruments in terms of sector, country, or currency, without duration constraints. It is not designed to track a specific benchmark, has less stringent or no limits on duration and sector exposure, and can use derivatives.

>•  We adopted the Morningstar fund category of “U.S. OE Nontraditional Bonds.” Morningstar defines this category as containing funds “that pursue strategies divergent in one or more ways from conventional practice in the broader bond-fund universe.” Within this fund category, we further excluded those funds with mandates in specific sectors or duration constraints to construct the sample data set.

>• Unconstrained bond funds have witnessed strong growth since the global financial crisis of 2007-2008. They have grown from 19 funds with assets under management (AUM) of USD 9 billion in 2008, to 122 funds with AUM of USD 140 billion as of November 2015.

>•  Unconstrained bond funds have collectively demonstrated strong correlation to global bonds and less return per unit of risk than core U.S. fixed income. However, they tend to have better downside protection.

>• Traditional style analysis of unconstrained bond funds has shown persistently high levels of cash allocation since 2011. In recent years, funds have increased allocation to cash and emerging market bonds at the expense of U.S. bonds.

>•  Principal Component Analysis (PCA) on fund returns finds that three independent factors collectively explain 69% of the variation of fund returns, with each of them explaining 54%, 8%, and 7%, respectively. The regression of sector returns versus factor returns indicates that the first Principal Component (PC1) represents the systematic force that drives returns of spread products; e.g., U.S. high-yield and emerging market bonds.

>• In recent years, the main investment strategy associated with this type of fund appears to be allocating to cash and spread products that have lower correlation to U.S. high-grade fixed income in order to reduce duration exposure. By doing so, the performance history of unconstrained bond funds exhibits lower correlation to core U.S. fixed income, with increasing correlation to the global fixed income market.

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