Unconstrained or Out of Control?

(March 25, 2014) — As the US Federal Reserve continues to taper its quantitative easing program, all eyes are on how institutional investors could rebalance their fixed-income portfolios in anticipation of rising interest rates.

“During the past 20 years, investors could buy any fixed income or credit asset and benefit from beta performance,” Rob Waldner, chief investment strategist for Invesco’s fixed income team, told aiCIO. “These assets did pretty well, especially in the last four to five years.”

That environment is coming to an end, according to Invesco’s February fixed income report. The bond market is in transition, leaning towards full valuations and yield-driven returns—and investors may need to get creative to ensure their portfolios could withstand volatility.

“It’s a different story today,” Waldner said. “Fixed-income yields are low and spreads are tight. Investors need to be mindful of managing credit exposures, and taking an active approach to the asset class.”

Going forward, institutional investors are expected to prefer active non-indexed strategies, looking for “exploitable advantages in security selection and asset allocation,” the report said. Traditional core bonds may not suffice in this changing environment, especially for funds seeking high returns within the risk budget.

Unconstrained fixed-income strategies may be something to consider.

“The unconstrained approach is great for funds that don’t really need to have duration in their portfolios,” Waldner said. “It makes a lot of sense for endowments and foundations [E&Fs]. It’s a more efficient way of getting fixed-income exposures in your portfolio—to generate good income and yield while reducing exposure.”

Scott Perry, an E&F specialist and partner at consultancy NEPC, agreed.

“Unconstrained fixed income has been a continuing trend in the endowment and foundation space for over three years,” Perry told aiCIO. “As E&F investor demand different fixed-income exposures in light of rising rates, they have found their portfolios held up better with lower duration.”

Unconstrained products are typically benchmarked against LIBOR + x%, or other cash-based benchmarks, and allow for more flexibility in duration exposure. Similar to absolute return strategies, they widen sector exposures and can dip into lower credit quality. But they can also have a hedge fund-like price tag: fees of 50 to 100 basis points are not uncommon. The strategy transforms interest rate risk into corporate credit risk and is said to behave more like equities than bonds.

These characteristics of unconstrained fixed income could help managers achieve higher returns, some experts have argued.

“By loosening some constraints on credit quality, currency, and risk exposures, and by allowing more out-of-benchmark investing, managers have a greater tool set for beating the index,” an NEPC report said. “Opportunistic and unconstrained fixed-income products generally maintain long-term strategic allocations to the major fixed-income sectors, but have the flexibility to express relative value views across markets and adjust allocations over time.”

NEPC’s Perry said it is precisely for these reasons that unconstrained strategies could take up more of investors’ fixed-income portfolios in coming months and years.

“We’ll continue to see these flexible mandates in 2014,” Perry said. “One example is PIMCO. We’ve been seeing a sizeable input to their unconstrained bond fund and an evident shift from its main total return fund.”

PIMCO’s unconstrained bond fund, created in June 2008, has more than $25 billion in total assets and is now the best selling alternative to traditional fixed income.

According to Morningstar, the fund saw inflows of $8.7 billion last year and Bill Gross, founder and co-CIO of PIMCO, replaced Chris Dialynas as manager of the fund in December. The firm announced Dialynas’ leave for sabbatical a month before Mohamed El-Erian’s resignation.

“With unconstrained bonds, the client is effectively delegating to PIMCO where to be and when in the fixed-income market to achieve the long-term return objective, whereas with total return, the client is specifying a bond market index and PIMCO’s mandate is to outperform by actively managing around that index,” Gross wrote in December. “Our goal is to provide a target absolute return with core-bond-like risk with an emphasis on shorter duration over time.”

This “one-stop-shopping” approach may be most advantageous to small endowments and foundations, according to NEPC’s paper.

“They may have a limited amount of resources to allocate to active long-only fixed income managers,” the report said. “Since unconstrained portfolios have the flexibility to invest broadly, the purpose of investing is based more upon return seeking, alpha generation, and broad diversification, and may not hedge the portfolio against certain economic conditions in the same manner as dedicated high quality nominal bonds or treasury inflation-protected securities (TIPS).”

Dennis Wilber, director of investments and treasury, at Visiting Nurse Services New York (VNSNY) said his fund’s switch to unconstrained mandates began in 2007. 

“We really needed something more flexible,” Wilber told aiCIO. “It helped us reduce volatility from major macro events and crises, allowing us to adjust quickly to changes in the market condition.”

VNSNY, a non-profit insurance company and healthcare provider, currently has $1.4 billion in three separate asset pools. Wilber said that since 2007, the fund has upped alternatives to 40% from 12% and flexible mandates to 58% from 8%.

“We have about a 10% allocation to fixed income,” Wilber continued. “But when we looked at our portfolio from a risk profile, we knew we needed to get rid of interest rate sensitive assets like TIPS and move into high quality government bonds and all asset funds.”

The healthcare provider recently added PIMCO as its global asset allocation manager, Wilber said, for the firm’s ability to move in and out of various funds with a wide array of strategies.

“It was important to become more dynamic in fixed income,” he said. “Spreads are narrow and liquidity is limited. Unconstrained mandates were a great element for diversification.”

However, investors need to be careful of increased manager risk, according to Goldman Sachs Asset Management. “The potential benefits of unconstrained fixed income depend on a manager’s ability to evaluate all available opportunities in the global fixed income market,” the firm wrote, as well as “select, and size positions according to the risk-adjusted return potential and employ tactical shifts and hedging strategies to manage risks.”

Wilber agreed and said concentrated manager risk was certainly a concern at first. To feel comfortable with the added exposure, his investment team had to implement a more robust risk management system. It now looks at quarterly and monthly performance reports, analytical manager risk and liquidity analyses, stress-test scenarios, and meets with every manager at least once a year on-site.

Despite the need for stronger and more thorough due diligence, unconstrained is still the way to go for many asset owners, according to Invesco’s Waldner.

“Seeking passive beta doesn’t make sense going forward,” he said. “The approach could help funds ease downside risk and hedge against volatility in uncertain times.”