Interest rates can turn quickly, as the Greek government learned when its 10-year bond soared more than 9 percentage points in the past year on default worries. Such danger has some fixed-income investors considering a new approach: mutual funds that hold a variety of bonds, including U.S. Treasuries, corporates, mortgage-backed securities, municipals, and senior bank loans. Especially attractive now are multisector funds touting a more active approach to portfolio management, with the flexibility to drift from benchmark allocations to respond to changing market conditions.
Fund tracker Morningstar (MORN) estimates that 22 so-called unconstrained bond funds currently manage a total of $53 billion in assets. That's roughly a quarter of 87 multisector bond funds Morningstar has identified with assets under management totaling around $169 billion. The new breed of fund accounts for just a meager fraction of the $2 trillion held by 1,127 taxable bond funds. Fund flows for 12 of the 22 unconstrained funds have generally trended higher since January, with five funds showing big spikes in April or May as the debate around the U.S. debt ceiling heated up. The strategies of these "go-anywhere" funds aren't uniform. Some focus on reducing their portfolio's average duration (the percentage by which a bond's value is likely to drop for every 1 percent rise in interest rates), while others concentrate on getting the highest yield for the least amount of credit risk.
"Multisector funds have been most popular because people are thinking, 'Is there a bond bubble?'" says Philip Condon, head of municipal bonds at DWS Investments in New York. "Investors recognize that Treasuries probably aren't the best value when you see yields" below 3 percent. "Multisector bond funds are offering the ability to find that value in the marketplace."
The nimbleness of these actively managed funds comes at a price. In place of interest rate risk, they often expose investors to elevated credit risk or, in the case of certain emerging market debt, liquidity risk. And some of these funds charge fees roughly twice as high as funds focused on a specific part of the fixed-income market, although high-yield and short-duration funds also tend to have higher fees. "In general, it's a pretty untested group," says Miriam Sjoblom, a bond fund analyst at Morningstar. "We don't have a long track record of seeing how these funds hold up in different environments."
When interest rates rise, bond yields move higher, pushing prices of existing bonds lower and causing investors to lose principal on the bonds in their portfolios. The best protection from this, many believe, is to lower the duration of the bonds they hold, which limits the loss of principal and allows fund managers to buy higher-yielding bonds sooner once interest rates begin to climb. A bond's duration measures how sensitive its price is to a change in interest rates and is calculated by taking the final maturity and yield into consideration.
Rick Rieder, BlackRock's (BLK) chief investment officer for actively managed fixed income and manager of the firm's Strategic Income Opportunities Fund (BASIX), is less concerned now about being burned by rising interest rates than he was six months ago, when the U.S. economy seemed to be on a more certain growth track. In late 2010 and early 2011, Rieder says he had a larger exposure to "risk assets," such as high-yield corporate bonds.
"We still have exposures to high yield and commercial mortgages but have reduced those exposures significantly over the last two months, mostly in anticipation of the end of quantitative easing 2 and increased volatility around that," he says. "The summer is a tougher liquidity period generally, and QE2 provided a tremendous foundation of liquidity because of what the Fed was putting into the system."
