There is no doubt that the past year was a challenging one for fixed-income investments: Intermediate- and long-term bond funds sold off, while the short-term bond category didnt return enough to buy a modest lunch. The only clear winners in the category were high-yield bond funds (with a total return of 7.55% for the 12 months ended Feb. 28) and bank loan funds (4.93%), according to preliminary figures compiled by Morningstar.
Between those extremes were multisector bond funds, which Morningstar says posted a return of 3.08% for the same period.
Multisector bond funds, sometimes called unconstrained funds, allow their managers great leeway in selecting investments. Depending on the fund, a manager can choose to buy high-yield corporates, foreign sovereigns, mortgage-backed securities or almost anything else that provides income.
Some planners see this class of funds as a valuable tool to use in their clients portfolios. Others are leery of the risk or prefer to do on their own what the fund managers are doing.
Fund managers, of course, emphasize that they are monitoring a vast universe of securities.
One of the things that people dont see is how incredibly diverse the bond market really is, says Jason Brady, portfolio manager of the Thornburg Strategic Income Fund (TSIAX), which Morningstar classifies as a multisector bond fund and rates four stars, out of a possible maximum of five.
Brady views the bond market as having a whole lot of different moving parts. And finding the right parts involves research. We are still sifting story by story, he says.
For the 12 months ended Feb. 28, the fund returned 6.01%. What weve been able to generate are returns approximating high-yield bonds but with far less volatility, he says. Most advisors are focused on duration.
They also tend to look at duration in terms of changes to Treasury yields, says Brady who contends that using Treasuries as a proxy for the entire bond market is worse than using the Dow ... as a proxy for global stocks.
Brady argues that people who dont regularly deal with the complexities of fixed-income securities cant easily replicate the funds results. Unless people are involved in the marketplace moment to moment or even year to year, in that kind of granularity theyre never going to be able to see the relative value, he says.
CHALLENGING MARKET
Advisor Rob DeHollander of DeHollander & Janse Financial Group in Greenville, S.C., doesnt hold Bradys fund, but he agrees with that assessment. I personally believe that the bond space is more difficult and complicated than stocks, says DeHollander, whose firm generally focuses its investment effort outside the fixed-income category. I think that we can provide more value for our clients in sector rotation in equities than in the bond space, he says.
DeHollanders firm uses three or four multisector bond funds in various mixes, depending on the clients needs. Lately, hes been putting money into PIMCO Income Fund (PIMIX), whose team won 2013 fixed-income manager honors from Morningstar.
In picking a multisector bond fund, DeHollander says he looks at several criteria, including longer-term performance and manager tenure. Performance isnt judged in isolation. We look at the risk levels that a fund is taking to get those returns, he says.
And a quarter or two of underperformance wont be a reason to sell the fund automatically. In a lot of cases, DeHollander says, the reason that they may be out of favor is that theyre right. Theyre just early.
MANAGER RISK
But the flexibility of multisector bond funds brings risk. There is a little more manager risk in this space, says Brian Kazanchy, a managing partner and wealth manager at RegentAtlantic Capital in Morristown, N.J.
His firm currently uses three go-anywhere funds, each with its own approach: JPMorgan Strategic Income Opportunities (JSOSX), PIMCO Unconstrained (PFIUX) and Eaton Vance Global Macro Absolute Return (EIGMX). We dont want three managers doing the same thing, Kazanchy says. RegentAtlantic sees these funds as a core position in client portfolios and aggregates them as a separate fixed-income asset class, along with short-term bonds and inflation-protected securities.
While Kazanchys firm chooses to delegate much of the fixed-income decision making to bond managers whose goals are in line with our views, he realizes other advisors may not take that path. I dont think any one approach is clearly right or wrong, he says.
IN-HOUSE MANAGEMENT
Indeed, John Frankola, president of Vista Investment Management in Pittsburgh, stays away from the category, determining fixed-income investments for clients himself. These are decisions Im capable of, he says.
As of last month, Frankolas fixed-income approach involved short-duration and high-quality (single-A or better) bonds. He was also underweight U.S. government bonds because the Feds buying programs have created strong demand and, he contends, left the securities somewhat overvalued.
Frankola is firmly in the no free lunch camp. If you want higher returns, you have to accept higher risk, he says. Thats not something hes prepared to do. This is the portion of the portfolio where we want preservation of capital. ... The biggest mistake investors make is to pursue return without regard for risk, he says.
Risk in multisector bond funds concerns Eric Jacobson, a senior fund analyst at Morningstar who follows the group. Before the financial crisis, we had very long stretches where credit produced very little volatility, and people thought that credit-sensitive funds were less risky than they were, he says. Now that the crisis is in the rear-view mirror, Jacobson says, three- to five-year measures may not look as problematic for funds that have taken on a lot of risk. I encourage people to look at yield as a risk flag, he adds.
Jacobson notes that the original idea of the multisector bond fund was to create an all-purpose fund that balanced out interest rate risk, credit risk and foreign bond risk. Now they tend to be much more aggressive, he says, citing large exposure to high-yield and emerging market bonds. He says that funds with a lot of high-yield exposure may have an internal balance, but suffer from greater sensitivity to equity movements.
Multisector bond funds used to hold more Treasuries and agency mortgages, Jacobson says, but those are out of fashion because of fears about rising interest rates. And stripping out those categories can leave a portfolio without an important form of insurance, he argues.
Jacobson suggests that advisors think of exposure to Treasuries and high-quality mortgages as a hedge. The only thing that provided any kind of ballast during the financial crisis was U.S. Treasuries, he says.
Many multisector bond funds behave much like the high-yield bonds that drive their performance. Advisors who prefer to use them may want to hold some top-quality bonds to serve as a counterbalance.
Joseph Lisanti, a Financial Planning contributing writer in New York, is a former editor-in-chief of Standard & Poors weekly investment advisory newsletter, The Outlook.
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