Rising interest rates and the challenges they present to fixed income investors are already here. The Federal Reserve has increased its pace of tapering to finish in March 2022 and will likely start rate hikes around the same time. Now that the secular bull market in U.S. Treasuries and the long period of low interest rates has come to an end, financial advisors are searching for fixed income solutions that can provide added value to client portfolios in what may now be a multi-year period of rising interest rates.
As part of this search process, advisors are likely to look at nontraditional bond funds. Investors look to these funds to both diversify their portfolios of equities and core bonds and to enhance overall portfolio returns.
The Morningstar Nontraditional Bond category, which is made up of nearly 300 funds, “contains funds that pursue strategies divergent in one or more ways from conventional practice in the broader bond-fund universe.” There are a wide variety of strategies lumped together under the moniker of “nontraditional bond funds,” so it is extremely important to look under the hood to really understand a specific fund’s investment approach and portfolio management strategy.
Many nontraditional bond funds invest in multiple asset classes—primarily corporate bonds (both high grade and high yield), sovereign debt, syndicated bank loans, securitized debt and U.S. Treasuries. Some describe their strategy as focused on absolute return while others define their investment mandate as entirely unconstrained. Many are long-only strategies while others employ various hedging strategies to manage interest rate or credit risk.
Here are five categories of key questions advisors and their clients should explore in evaluating a nontraditional bond fund:
1. Performance And Alpha: Does the fund provide enhanced returns when compared to the benchmark and other nontraditional bond funds? More importantly, does it enhance returns when added to the rest of the client’s portfolio? Does it truly provide Alpha?
2. Low Correlation: Does the fund truly provide diversification? How does it correlate to the benchmark? But again, importantly, how does it correlate to the rest of the client’s portfolio?
3. Solution For Rising Interest Rate Period: How has the fund performed historically in rising interest rate environments? Has the current team managed through rising interest rate cycles before? Does the fund employ a cost-effective strategy to manage interest rate risk? Given the challenge of rising interest rates should the fund not just supplement, but potentially even replace some portion of a client’s core, core plus or other traditional fixed income portfolio?
4. Experience With Other Market Challenges: How did the fund respond to the challenges of the Covid-19 pandemic and what were the results? Is the fund able to nimbly adjust portfolio positions in its focus sectors to effectively play both offense and defense as market conditions change rapidly? It is one thing to know what to do—to have a plan—but quite another to execute that plan. Does the fund’s portfolio construction enable it to quickly “move the ship” out of harm’s way or to pursue a desired catch?
5. Communication And Accessibility To Portfolio Managers: Do the fund managers describe the strategy and their market views in a clear, concise and understandable manner? Are they readily available to both advisors and their clients?