Even though unconstrained bond funds as a group did poorly last year at a time when Treasuries continued their improbable rise, Holtzman says he's more concerned about another kind of risk--excessive correlation to non-bond indices. "If these funds are allocating too much to high-yield and international bonds, which have developed a strong correlation to the S&P 500 over the last five years, the fund will not diversify the overall client portfolio," he notes. ?

Matt Reznik of Balasa Dinverno Foltz LLC, based in Itasca Ill., is also a fan of unconstrained bond funds. "We use these funds for their flexibility, to increase diversification and to prepare for a rising rate environment," says Reznik, whose firm uses the Pimco Total Return A (PTTAX), Pimco Unconstrained Bond A, Loomis Sayles Bond Retail (LSBRX), and JP Morgan Strategic Income Opportunities A funds.  

Reznik says his firm uses PTTAX as a core holding, and that the other funds fit into its multi-sector bond holding strategy because they're less tied to a benchmark and follow flexible duration strategies. "It's important to examine the strategies of each fund," he says. "LSBRX will be more correlated to equities at times, due to its corporate and international exposure, while JSOAX can even go short."

He notes that he uses these funds for 40% to 60% of his clients' bond exposure, and prefers to hold them in tax-deferred accounts due to their higher level of current income.

Reznik acknowledges that unconstrained bond funds are not bullet proof. "The biggest risk is that they are actively managed funds and can make a big bet that goes awry," he says. "PTTAX made an erroneous bet against Treasuries in 2011 and lags as a result. LSBRX had a poor 2008 due to its corporate bond exposure, but both have excellent long term track records."

Reznik notes that some of the appeal of unconstrained bonds funds rests with the peculiarities of the current environment. "Real interest rates are at historic lows, creating a unique interest rate environment," he says. "In our view, funds like JSOAX and PUBAX  are appropriate in the current environment because they have the most flexibility in managing the yield curve, and have the ability to go negative on duration."

Funds that go short and frequently change exposures are difficult to manage in an asset allocation model. But advisors concerned about the potential for rising rate scenarios should consider that these funds are likely to outperform in these scenarios.

Using PTTAX and LSBRX as core holdings, and supplementing them with more flexible funds like JSOAX and PUBAX, will give advisors access to heralded bond managers with superior long-term track records. These funds certainly aren't plain vanilla, but their strategies may add a pleasant spice to clients portfolios.

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