BlackRock currently estimates that core CPI, a key measure of inflation, will peak at around 2.5%, while the Fed’s preferred measure, personal consumption expenditures, or core PCE, will reach 2.2% in 2018. The low inflation amid economic growth stems from technology continually disrupting prices, Rieder says.
If growth and inflation were to continue, Gaffney believes that U.S. Treasurys could produce negative returns moving forward. “When inflation becomes more important, you start to think about your total returns,” says Gaffney. “For fixed income, with low rates at the high-quality end of the market, and low rates for taking additional credit risk in high yield or emerging market, the risk that inflation eats away at your total return becomes the more important risk for investors to think about.”
Market volatility is also a driver of interest rates: The S&P 500 just experienced its first quarterly loss in nearly three years and intransigent long-term interest rates finally began to creep up in April.
The ability of unconstrained managers to hedge credit risk or adopt short positions might appeal to investors facing down this future volatility and uncertainty. Gaffney says these funds are also managed by absolute return, “which implies a positive return every single year, which is very difficult to do.”
Rieder also sees more volatility in 2018.
And Guggenheim believes that as the economy reaches full employment, as interest rates rise and as wage inflation sets in, recession risks increase as corporate debt squeezes an increasing proportion of companies.
Investors should take caution, since managers may mis-time the market or make a wrong call that ends up destroying wealth, says Todd Rosenbluth, director of fund research at CFRA.
“There is a risk that these managers aim to zag when the market actually zigs,” says Rosenbluth. “Even though the Fed has laid out a road map for its rate hikes, they’re by their own words data dependent. It’s not clear how these funds will be constructed in the future and how the way the fund is constructed will serve the intention of the investor.”
Unconstrained strategies are so diverse, the funds defy easy definition, says Rosenbluth. Many funds, he adds, are so new they do not have long enough track records for sufficient analysis, and their short positions make it difficult to understand how the strategies are allocated.
Because some funds exchange interest rate risk for other types of risk, the nontraditional category ends up with a higher correlation to credit-sensitive investments and equity markets. According to Morningstar, non-traditional funds allocated more than one-third of their assets to bonds with below-investment-grade ratings.