Nontraditional bond funds had a following after the financial crisis when interest rates were at all-time lows. Fund inflows tripled between 2011 and 2014, according to Morningstar and the Financial Industry Regulatory Authority, as many investors sought solace in nontraditional bond funds to get higher returns and preserve their capital.
With interest rates rising, do these funds still belong in a small investor’s portfolio?
Unlike traditional bond funds that invest in investment-grade corporate bonds, U.S. Treasurys and municipal bonds, nontraditional funds may invest in alternative sources of fixed income to offset interest rate risk. By investing in fixed-income alternatives, such as high-yield bonds, emerging market debt, mortgage-backed securities and credit derivatives, nontraditional bond funds take on higher credit risk.
[See: 9 Ways to Invest in America With Bond Funds.]
Many nontraditional bond funds are unconstrained, meaning they can invest in anything. Even though investors don’t always realize it, these nontraditional “go anywhere” bond funds are akin to multi-asset bond funds because both invest in the same universe, says Cliff Caplan, founder and president of Neponset Valley Financial Partners in Norwood, Massachusetts.
Unlike multi-asset bond funds, nontraditional bond funds can hold a significant percentage of the portfolio in cash. As a result, their performance tends to lag multi-asset bond funds and intermediate bond funds when interest rate risk is low, Caplan says. Then, nontraditional bond funds have averaged returns that are not much higher than an investor would get with a money market savings account at a bank.
As interest rates creep up, bond funds in general make investors nervous. “There is fear that as interest rates go up you could lose a lot of money in the bond market,” Caplan says. Bonds and interest rates have an inverse relationship. When interest rates rise, bond prices fall, with some falling more than others depending on the bond’s duration, currency and credit risk.
By investing in riskier bonds, nontraditional bond funds could expose investors to more risk without generating decent returns. But the funds may have one saving grace worth considering.
They target interest rate risk. In down bond markets, as other bond funds decline from interest rate fears, nontraditional bond funds can do extremely well. That’s because unlike other bond funds, nontraditional funds can use negative duration, a strategy to hedge against rising rates.
[See: 11 of the Best Fixed-Income Funds to Buy.]
For example, when interest rates rise, the funds may use derivatives, or contracts to speculate on bond prices, to make nontraditional bond prices go up instead of down. “Nontraditional bond funds will shine in down bond markets, if they’ve successfully used negative duration,” Caplan says.
This happened during the 2013 “Taper Tantrum” when the Federal Reserve curtailed its bond-buying program, prompting investors to pull out of the bond market. That caused yields to drastically increase before leveling off. The one exception, Caplan says, was the nontraditional bond market that used negative durations. “If you are fearful of the impact of rising interest rates, consider using a nontraditional bond fund [with] a manager who has effectively employed the use of negative duration before,” says Caplan.
He cites JPMorgan Strategic Income Opportunities Fund (ticker: JSOAX) as having such a manager. In 2013, when almost all bond funds were down, this fund earned 3 percent in total returns, thanks to negative duration, Caplan says. Even though it missed the mark in 2015 with 2.5 percent, the fund skyrocketed up a year later with a 9.1 percent total return before tapering off to 3.1 percent this year.
Nontraditional bond funds have a reputation for being expensive, especially if they use negative duration. According to FINRA, the funds charge fees that are about 1 to 2 percent higher than other bond funds. The JPMorgan Strategic Income Opportunities fund charges an initial 3.75 percent, or front load, and an annual expense ratio of 1.02 percent.
Because nontraditional bond managers are interested primarily in preserving capital, investors will usually only get a 3 to 5 percent return on average, Caplan says, but some years the funds can be flat or negative. “If a manager lost 2 to 3 percent, that should raise a major eyebrow,” he says. If that’s a recurring theme, investors should avoid using that manager.
Derivatives aren’t always the answer to rising rates. Even though Caplan advocates nontraditional bond funds for their use of derivatives to create negative duration, other financial advisors caution that the methodology is complicated. “Depending on when you got in or got out, you can make money or lose money,” says Holmes Osborne, principal of Osborne Global Investments in Santa Monica, California. “I don’t do any of that funky stuff [like derivatives]. The average person is better off not using them.”
Jason Ware, managing director and head of institutional trading for 280 CapMarkets in San Francisco, echoes that sentiment. “Derivatives are complicated securities,” he says. There’s such a small derivatives market that the fund is beholden to whatever a dealer or bank is willing to pay for derivatives, Ware says. “It’s about supply and demand and who is willing to make it a market.” So if derivatives don’t have an equal uptick in value as interest rates rise, the funds will massively underperform, he says.
The funds won’t be much help in a crisis. Market, commodity and currency risk can also play a major role in how a nontraditional bond fund does. “When the financial market collapsed, nontraditional bond funds got crushed,” Osborne says. “I saw a guy who had a million dollars go down to $400,000 and then eventually had it bounce back.” So check the section about risk in a fund’s prospectus. “Legally they have to detail all the potential risks, including any credit risk and interest rate risk,” says Joel Salomon, founder of SaLaurMor in New York.
Still, if you are concerned about interest rate risk, the funds have merit and are a better way to go than buying nontraditional bonds directly yourself. Unlike the bonds themselves, which aren’t always easy to unload, nontraditional bond funds offer investors an easier way out. Osborne says he has a client now who inherited 50 Federative Republic of Brazil bonds that his mother purchased at $1,000 a share. They are now only worth 33 cents on the dollar and don’t mature until 2028. Osborne says his client tried to sell the bonds, but Brazil mandates that the seller must have at least 250 bonds to sell, so the client is stuck with the bonds. If this were a bond fund, the investor could quickly sell it, Osborne says.
[See: 9 Investing Steps From Warren Buffett’s Playbook.]
The fund’s professional manager may also be better than you at spotting good buying opportunities. In some instances, nontraditional bonds can be undervalued and a good deal, Osborne says, as in the case of Kansas City Southern railroad, an unrated bond series that a stable blue-chip company holds, or Zurich RE, a reinsurance company that Berkshire Hathaway purchased.
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Should You Own Nontraditional Bond Funds? originally appeared on usnews.com
