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Lonsec Research   ⟩   News & Insights   ⟩   News   ⟩   Unconstrained bonds and hidden risks
Jude McDonnell

AuthorJude McDonnell

TitleHead of Income & Multi Asset

DateDecember 19, 2018

CategoryNews

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It is easy to see why the unconstrained approach is so appealing to investors. By taking a ‘benchmark agnostic’ view, an unconstrained bond manager can actively position their portfolio based on their view of the future direction of yields or relative performance between sectors. This flexibility not only allows unconstrained managers to outperform the benchmark with the right strategy but can also provide additional diversification benefits due to low correlations with passive bond and equity funds.

With central banks locked in a tightening cycle, market volatility re-emerging after a period of relative calm, and geopolitical risks wreaking havoc in emerging markets, you might think unconstrained bond funds were made for these times. But assessing the effectiveness of unconstrained bonds means contending with the significant diversity within the sector, which combined with the relatively short track record of most unconstrained managers makes it difficult to assess performance through different market conditions. To understand how a particular fund might behave within a broader portfolio, investors need to get under the hood to see how the manager is generating returns and where they might be exposed to risk.

Lonsec’s peer group of unconstrained bond managers is indicative of both the growth within the sector as well as the diversity of strategies employed. Over the period from April 2017 to November 2018, most of these funds provided some level of diversification, with relatively low correlations against major equity and fixed income indices. However, Lonsec’s research shows that many unconstrained bond funds have to date been significantly correlated with high yield fixed income benchmarks, reflecting the additional credit risk inherent in many unconstrained strategies.

Unconstrained bond funds may have equity- or credit-like behaviour depending on their strategy
(correlation of returns with US equities and high yield indices)

Source: Lonsec

This means that when high yield credit is underperforming, unconstrained funds may also underperform. The correlations are varied, which is largely due to the broad range of investment styles employed across the peer group.

The majority of funds in the peer group have exhibited a positive correlation to global equities (S&P 500 TR Index AUD) and emerging market equities (MSCI Emerging Markets TR Index AUD)—largely driven by their allocations to both investment grade and high yield credit—but have still provided some level of diversification away from these markets given less than perfect correlations. Ideally, unconstrained bond funds are expected to meet their return and risk targets while avoiding high correlations with high yield and equity. The purpose of unconstrained investing is not simply to provide a direct substitute for these higher risk alternatives—investors are looking for more flexibility, not necessarily more risk.

Investors should consider unconstrained bonds but should be confident that they understand what individual managers are trying to achieve. Is the fund using duration as a driver of alpha? Is it predominately defensive in its allocation? Does it employ leverage to amplify returns? Unconstrained bonds can help investors diversify their portfolio and provide additional alpha, but it is essential that investors have an idea of how the fund is likely to behave in different market conditions, especially when riskier sectors start heading south.

To find out more about Lonsec’s fixed income and unconstrained bond research, sign up for a free research trial or get in touch with our client services team.

IMPORTANT NOTICE: This document is published by Lonsec Research Pty Ltd ABN 11 151 658 561, AFSL 421 445 (Lonsec).

Please read the following before making any investment decision about any financial product mentioned in this document.

Warnings: Lonsec reserves the right to withdraw this document at any time and assumes no obligation to update this document after the date of publication. Past performance is not a reliable indicator of future performance. Any express or implied recommendation, rating, or advice presented in this document is a “class service” (as defined in the Financial Advisers Act 2008 (NZ)) or limited to “general advice” (as defined in the Corporations Act (C’th)) and based solely on consideration of data or the investment merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person.

Warnings and Disclosure in relation to particular products: If our general advice relates to the acquisition or possible acquisition or disposal or possible disposal of particular classes of assets or financial product(s), before making any decision the reader should obtain and consider more information, including the Investment Statement or Product Disclosure Statement and, where relevant, refer to Lonsec’s full research report for each financial product, including the disclosure notice. The reader must also consider whether it is personally appropriate in light of his or her financial circumstances or should seek further advice on its appropriateness. It is not a “personalised service” (as defined in the Financial Advisers Act 2008 (NZ)) and does not constitute a recommendation to purchase, hold, redeem or sell any financial product(s), and the reader should seek independent financial advice before investing in any financial product. Lonsec may receive a fee from Fund Manager or Product Issuer (s) for reviewing and rating individual financial product(s), using comprehensive and objective criteria. Lonsec may also receive fees from the Fund Manager or Financial Product Issuer (s) for subscribing to investment research content and services provided by Lonsec.

Disclaimer: This document is for the exclusive use of the person to whom it is provided by Lonsec and must not be used or relied upon by any other person. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information not verified by Lonsec. Conclusions, ratings and advice are reasonably held at the time of completion but subject to change without notice. Lonsec assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the information.

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For more information contact:

Gordon Toy
03 9623 6373
Gordon.Toy@lonsec.com.au

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