Finding Gems -- and Risks -- in Alternative Bond Funds

Assets in Morningstar’s Nontraditional Bond fund category have grown tenfold since the end of 2009 to $80 billion, $12.5 billion of which came in this year. Photograph by Jeff Hunter Close

Assets in Morningstar’s Nontraditional Bond fund category have grown tenfold since the... Read More

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Assets in Morningstar’s Nontraditional Bond fund category have grown tenfold since the end of 2009 to $80 billion, $12.5 billion of which came in this year. Photograph by Jeff Hunter

Remember, back in the Paleolithic age, those “alternative music” bins they had at old record stores? They were always intriguing, but when you put the headphones on you never knew what you were going to get. The mutual funds listed in Morningstar’s Nontraditional Bond fund category are kind of like that. And, as with the record bin, sometimes you find some real gems --- and sometimes you find incomprehensible noise.

Names like Pimco Unconstrained (PFIUX), Eaton Vance Global Macro Absolute Return (EIGMX) and Driehaus Active Income (LCMAX) don’t have the same sex appeal as Nirvana or Smashing Pumpkins. Some of these alt funds have become just as popular in their own way, however. Assets in the group have grown tenfold since the end of 2009 to $80 billion, $12.5 billion of which flooded in this year. That’s despite the fact most of the funds are less than five years old and have strategies that are as challenging to classify as music that gets tossed into "alternative" with a shrug.

Seeking Absolute Returns

Morningstar created the nontraditional category in October 2011 in response to the popularity of these kinds of funds. About the only thing consistent to the group is how the funds are advertised. “They’re marketed as absolute return funds that will perform especially well in rising rate environments,” says Eric Jacobson, a senior fund analyst at Morningstar. “They try to make up for that lack of interest rate risk, usually by taking some other kind of risk to generate returns.”

The idea of an absolute return strategy is to make money in every kind of market. The problem: While trying to avoid interest rate risk, the funds simultaneously take on other risks that have nothing to do with interest rates -- credit risk, for instance.

Some funds, such as Pimco Unconstrained and Pimco Floating Income (PFTAX), buy emerging market, junk and mortgage bonds while shorting, or betting against Treasuries and other government bonds via derivatives to neutralize the interest rate risk. Eaton Vance Global Macro Absolute Return Fund, meanwhile, uses a long-short currency strategy, betting on, say, a rise in the Turkish lira and a fall in the Brazilian real. The Driehaus Active Income fund employs a mouthful of a strategy called capital structure arbitrage, which involves going long and short different bonds issued by the same company.

Rising Rate Test

While many of these funds may do well if rates rise, none of them have been tested in a strong rising rate environment. Rates have been falling since 1981. Moreover, only 11 of the category’s 55 funds existed during 2008’s credit crisis when rates fell sharply and Treasury bonds rallied. And that wasn’t a pleasant experience. The average nontraditional fund fell 11.5 percent while more conventional intermediate-term bond funds rose 5.9 percent and the Treasury-laden Barclays Aggregate Bond Index gained 6.5 percent that year.

Still, because the category is so eclectic it’s unfair to paint all of these funds with the same brush. Consider the two Pimco funds. Though it's in the nontraditional category, Pimco Floating Income is designed specifically to benefit from rising rates -- not to do well in any market. So it’s understandable that it lost 24.7 percent in 2008’s crash and 9.3 percent during 2011’s volatile third quarter. Pimco Unconstrained is more of a true absolute return fund that can invest anywhere. Launched in June of 2008, it lost 1.1 percent during 2011’s third quarter.

Then there’s the $5 billion FPA New Income (FPNIX), the oldest fund in the group. It doesn’t short or use derivatives, and since 1984 it has truly delivered absolute returns. “We’ve been tested several times and have never had a negative 12-month return,” says manager Thomas Atteberry. What FPA does is keep bond maturities short -- less than five years -- and credit quality high so that it doesn’t lose money. The fund has delivered 2.8 percent annualized return for the last five years.

Category Kvetching

Some managers think the nontraditional bond category is too vague. “We’re not a nontraditional bond fund," says K.C. Nelson, manager of the Driehaus Active Income Fund. "We’re a liquid hedge fund strategy.” Because Nelson actually ran a hedge fund and now practices a specialized kind of arbitrage for a relatively small fund shop, he resents being lumped in with other funds run by managers at big companies.

Nelson argues that such managers often have scant experience with hedging and do little of it. "There are truly hedged strategies and then there are long-only strategies with just a tiny bit of hedging that qualifies them as nontraditional,” he says. Unfortunately, the only way to separate the hedge fund poseurs from the true rock stars is to experience another crash.

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