Walsh’s Unconstrained Wins in Bond Rout: Riskless Return

Steve Walsh, who manages the Western Asset Total Return Unconstrained Fund, was able to limit bond losses in May and June as top-ranked managers including Bill Gross stumbled amid a Treasury selloff.

Walsh, Western Asset Management Co.’s co-chief investment officer, had one advantage over generalist fixed-income managers like Gross: His holdings don’t have to track traditional benchmarks and he can use hedging to react to market shocks. Over the past three years, Walsh’s $603 million Western Unconstrained fund produced the best risk-adjusted returns among 17 similar U.S. bond funds, the BLOOMBERG RISKLESS RETURN RANKING shows.

“There isn’t a sector within fixed income that we can’t take advantage of in this portfolio,” Walsh, 54, who’s based in Pasadena, California, said in a telephone interview. “You can really manage without regard to some pre-determined benchmark allocation.”

Money managers from Legg Mason Inc.’s Western Asset unit to BlackRock Inc. are betting that bond funds that aren’t constrained by duration, strategy or region will attract money as interest rates start to rise and investors shift assets from traditional fixed-income offerings, which are limited in how they can react to falling bond markets. Pacific Investment Management Co. also has an unconstrained strategy, which has beaten Gross’s flagship $268 billion Pimco Total Return Fund over the past year.


Asset managers started pushing these “go-anywhere” bond funds after the 2007-2009 financial crisis, when interest rates declined to near zero, leaving little room for bonds to extend their three-decade rally. Bond prices fall as interest rates climb. Unconstrained funds generally can have negative duration, meaning the portfolios will increase in value when interest rates rise, and some can use hedge-fund techniques such as shorting, or betting on a decline in the price of securities.

BlackRock Chief Executive Officer Laurence D. Fink, who oversees the world’s biggest money manager, said this month he’s seeing clients shifting to flexible bond strategies. Investors put $28 billion into non-traditional bond funds this year through June 30, almost one-third of the total net assets in the funds, according to the Chicago-based Morningstar Inc. In the same time, investors pulled $16.3 billion from intermediate-term bond funds.

Low Duration

Walsh has kept the fund’s average duration, a measure of sensitivity to rising rates, of his unconstrained bond fund at 2.65 years as of July 29, compared with about 5.5 years for the Barclays U.S. Aggregate Index, the most commonly used benchmark for fixed-income managers. Over the past three years, Walsh has moved the fund’s duration from as low as 1 year to as high as 3 years. A fund with a modified duration of 10 would be expected to fall roughly 10 percent in price for every 1 percentage point increase in interest rates.

The Western Asset Total Return Unconstrained Fund returned a risk-adjusted 7.8 percent in the three years ended July 29. The fund combined above-average cumulative returns of 13 percent and the third-lowest volatility of 1.66 since July 2010 among the 17 non-traditional funds. The ranking looked at funds with assets of more than $250 million and in existence for at least three years within a group of 61 bond funds defined as unconstrained or non-traditional by Morningstar Inc.

Goldman Fund

The $414 million Delaware Diversified Floating Rate Fund ranked second in the risk-adjusted rankings over the past three years, with an adjusted return of 7.2 percent and the lowest volatility. The $593 million Mainstay Unconstrained Bond Fund ranked third after the highest absolute return and above-average volatility resulted in a risk-adjusted performance of 6.5 percent. The $5.4 billion Goldman Sachs Strategic Income Fund was the fourth-best performer over the past three years with a risk-adjusted return of 6.4 percent.

The risk-adjusted return isn’t annualized. It’s calculated by dividing total return by volatility, or the degree of daily price variation, giving a measure of income per unit of risk. Higher volatility means the price of an asset can swing dramatically in a short period, increasing the potential for unexpected losses.

Walsh was able to limit volatility over the past three years by betting against the euro during the European sovereign debt crisis versus the U.S. dollar. By wagering against the euro, he was able to mitigate the impact of falling prices elsewhere in the credit markets. Walsh also owned long-duration Treasury bonds, which outperformed when other areas of the credit market or emerging-market debt suffered.

As of June 30, Walsh’s fund had 24 percent invested in cash and other securities, 23 percent in investment-grade corporate bonds, 18 percent in government securities and 17 percent in mortgage-backed securities, according to Western Asset’s website.

2008 Decline

Walsh, who’s been managing the Western fund since it started in July 2006, said he realized the importance of hedging even more when the fund dropped 15 percent in 2008 as a rout in the credit markets hurt all but the safest government-backed bonds.

This year, the Western Asset fund was able to limit losses as concerns that rates will rise sparked a 3.2 percent decline in the Bank of America Merrill Lynch U.S. Treasury & Agency Index in May and June. Walsh’s fund fell 1.6 percent on an absolute basis in the two months ending June 30, compared with a 3.3 percent loss in the Barclays Aggregate index and a 4.7 percent decline for Gross’s Total Return fund, according to data compiled by Bloomberg.

Treasury Selloff

Federal Reserve Chairman Ben S. Bernanke on May 22 told Congress the U.S. central bank might pull back its unprecedented stimulus. Bernanke followed with comments on June 19 that the Fed might scale back its $85 billion a month of bond buying this year and end it by mid-2014. The yield on the 10-year Treasury note reached 2.75 percent on July 8, the highest since August 2011, from a low this year of 1.61 percent on May 1.

One of the caveats with unconstrained bond funds is that by limiting duration risk, or potential losses from an increase in interest rates, they often have to increase credit risk, by buying debt from lower-quality issuers, said Eric Jacobson, a senior fund analyst at Morningstar. It’s also difficult for managers to pinpoint where rates are going and set the duration for these funds, which may range from minus 3 years to 8 years, he said.

“There are very few managers able to anticipate interest rate moves consistently,” Jacobson said. “Even someone like Bill Gross, who has a history of being able to do it, hasn’t gotten through this last period without some pain.”

Pimco Unconstrained

Gross’s Pimco Total Return Fund had a risk-adjusted return of 2.8 percent over the past three years and a duration of 5.82 years as of June 30. On a total return basis, Gross beat the Western unconstrained fund over the past three years. Pimco’s Total Return fund advanced 14 percent since July 2010 compared with 13 percent for the Western fund.

The main difference between Gross’s mutual fund and unconstrained funds is duration: Pimco Total Return’s prospectus says the average portfolio duration of the fund normally stays within two years of the portfolio duration of the Barclays Aggregate index. While Gross can make use of derivatives such as credit default swaps, the fund primarily invests in investment-grade debt securities.

The $27.7 billion Pimco Unconstrained Bond Fund, which started in June 2008 and is managed by Chris Dialynas, is the largest of the non-traditional bond mutual funds tracked by Morningstar. The fund placed ninth in the group over the three-year period, according to data compiled by Bloomberg. The fund had $9.2 billion in deposits this year, the most out of all active mutual funds, according to data from Morningstar.

“Our approach is to provide our clients with a range of strategies that are designed to help investors meet their objectives,” Michael Reid, a spokesman for Newport Beach, California-based Pimco, said in an e-mailed statement. “This is reflected in the response we have seen to our unconstrained strategies.”

BlackRock ‘Rotation’

At BlackRock, which oversees about $4 trillion, non-traditional bond offerings include the $7.1 billion BlackRock Strategic Income Opportunities Portfolio.

“We are seeing a rotation at BlackRock, but it’s not from fixed income into equities -- it’s a rotation within fixed income,” CEO Fink said during a conference call with analysts and investors July 18. “We expect to see flows moving into more flexible, non-traditional fixed-income products.”

The BlackRock fund, run by CIO for fundamental fixed income Rick Rieder, placed fifth on a risk-adjusted return basis over the past three years. This year, the fund is focused on securities including floating-rate bonds, commercial mortgages and asset-backed securities now that prices have declined, Rieder said in an interview.

“Being tethered to a duration and interest rate sensitivity of so long is going to be dangerous in an environment where interest rates almost certainly have to rise from the levels they’ve been at,” Rieder said. “This is a much more elegant way to manage fixed income.”

Tactical Approach

Since May 22, Western Asset’s Walsh has added more U.S. high-yield bonds and agency mortgages, and extended the duration of the fund. Walsh said he extended the duration because the market was overreacting to Bernanke’s comments.

Walsh said he’s prepared to be tactical as 10-year Treasury yields have risen to 2.61 percent as of July 30. If Treasury yields fall to 2.25 percent, he’ll cut the duration of the fund, and if they fall to below 2 percent, he will short the Treasury market.

“There’s the ability to not run as consistent with a market duration,” compared with benchmarks, Walsh said. “I think that’s the biggest reason, especially where we are in the rate cycle, why it’s attractive.”

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