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The Risks of Unconstrained Bond Funds

The Risks of Unconstrained Bonds Funds

Given the prolonged low rate interest environment, the search for yield is becoming an increasingly difficult task. As a result, unconstrained bond funds continue to be a popular solution. Although the yields seem relatively attractive, many investors are underestimating how far up the risk scale they can be once invested in these sorts of vehicles. When investing in funds, investors are usually enticed by the idea of professional management and diversification. However, as with any investment, there are risks and unfortunately they are generally less obvious, especially in unconstrained bond funds.

  1. Structure

Bond funds are a perpetual investment. While individual bonds generally have a specified maturity, a fund does not. As a result, bond funds are not obliged to pay out any principal received that otherwise would have been in an individual bond investment. Although an individual bond’s price will fluctuate during its term, it will always approach its principal value as it reaches maturity and as long as the underlying issuer does not default, investors will receive the stated yield to maturity. This is known as bond price trajectory. On the other hand, a bond fund will always fluctuate with the market value of the underlying bonds in the fund and resulting the price trajectory effect will be weaker. Therefore, fluctuations in value are much more uncertain for bond funds.

  1. Unconstrained Mandate

Unconstrained bond funds do not have limitations on which bonds to invest in. This means that the underlying portfolio can contain bonds with any credit rating, from any sector within any country. Additionally, unconstrained bond funds are generally not required to follow one specific benchmark which further decreases transparency when investing. To accommodate the global yield demand, this significantly increases risk of this type of investment as many companies with sound credit profiles are unable to offer attractive yields in the given interest rate environment. As a result, unsuspecting investors may be exposed to extremely risky companies that are rated below investment grade or not rated at all.

  1. Complexity

While the fixed income asset class is generally used as a risk mitigant, the complexity of unconstrained bond funds can offset these risk-reducing benefits. The underlying portfolio must track investments in a variety of different markets which vary in risk. This means that there are more variables that can adversely affect the value of the underlying bonds and as a result, the cost of monitoring these variables is far greater than simpler vehicles such as Exchange Traded Funds (ETFs). These costs are most likely to be passed on to the investor and is one of the primary reasons why fees are often higher in unconstrained funds. Another layer of complexity comes with measuring performance. Unconstrained funds must use multiple benchmarks to account for different geographical areas and different levels of risk. This makes comparability near impossible when evaluating alternative funds and investors may misjudge the stated return the fund is offering on a per risk basis.

  1. Leverage

Many unconstrained bond funds utilise leverage through the application of derivatives and swaps enabling the underlying portfolio to take on short positions (betting that the price of a bond will decline). Another leverage technique is borrowing funds to purchase additional securities (increasing the portfolio’s exposure). This is known as buying on margin and the existing bonds in the fund serve as collateral for the money borrowed. The amplifies the portfolio’s profit or loss in.. Although some investors are comfortable to the additional risk, many fail to realise the rate of return on the fund is reduced by the loan’s interest expense. This means that investors are essentially not being rewarded for the full extent of risk they are exposed to.

 

The Bottom Line

While bonds are supposed to be a source of diversification in a multi-asset portfolio, unconstrained bond funds tend to have the opposite effect. Unlike traditional bond strategies, these funds are able to invest anywhere resulting in higher correlation with riskier asset classes (i.e. equities) in periods of volatility. This opposes the defensive nature of fixed income which is primarily utilised for capital preservation and income generation. Therefore, unconstrained bond investment could not only have consequences for your initial capital investment, but also for other investments within your portfolio due to reduced diversification. If the chosen unconstrained fund fluctuates with stocks more than traditional fixed income securities, the unsuspecting investor could be more at risk than appears on the surface. This may force investors to think twice before blindly chasing yield.