Glassman uses active bond funds, but each has a clear approach that he understands, and he is prepared to monitor when the approach changes. One is the Templeton Global Bond Fund (TPINX) led by Michael Hasenstab, which over the long-term (both 10- and 15-year periods) ranks highly among peers. The Templeton fund owns emerging markets debt — a risky area right now given concerns about the strong U.S. dollar and years of dollar-based borrowing in the region — but Hasenstab also shorts various global currencies as part of his strategy. So even when the dollar soared after Trump's election and overseas bonds got hit hard, the fund was positive because of currency shorts.
Even with core bond exposure for retirement assets, Glassman wants an average maturity of bonds that is lower than the Barclays Agg at a time of rising rates and depreciating bond prices. He has been using the Dodge & Cox Income Fund (DODIX) which has an average duration of 4.4 vs. 5.9 for the Barclays Agg. The Dodge & Cox fund has outperformed most peers recently, and over the long-term, consistently beating the benchmark.
Mitch Goldberg, president of investment advisory firm ClientFirst Strategy, said there are so many bond ETFs available today that advisors and investors worried about rising U.S. interest rates can create a strategy of varying maturities and geographies without having to use an active bond manager. He said the idea of unconstrained bond investing makes sense: an investor can achieve not only income but total return that is uncorrelated to the rest of the bond market. But when these funds are generating returns no better than, or even worse than, a core bond ETF like the Vanguard Total Bond Market Index Fund (BND), investors are going to be disappointed. "Active managers need long lead times," he said.
The era of quantitative easing tamped down the volatility not only in the stock market but bond market as well, and that makes it harder for unconstrained managers to find the arbitrage opportunities between sectors. "Everyone has to acknowledge that central bank policy has tamped down volatility and reduced the need for active management. It won't be like that forever. But for a monster-size manager like Gross, his best days were before central bank policy saved the universe," Goldberg said. Unconstrained managers need more volatility and more frequent narrowing and widening of spreads between bond asset classes.
5 unconstrained bond funds that are outperforming
Here are the five top alternative credit funds over the past one-year period, according to Lipper data, and the strategies their managers have targeted:
Highland Opportunistic Credit Fund (HNRAX)
One-year return: 10.5 percent
While this fund refers to itself as an unconstrained strategy, Morningstar classifies it as high-yield and co-manager Trey Parker said his fund prefers to invest in companies that are undervalued or misunderstood. He pointed to Fieldwood Energy as a good recent investment, noting that the loan appreciated from 60 cents on the dollar to 98 cents.
"We really are industry agnostic, so we will invest across industries depending on the opportunity set," he said. "We've invested in healthcare and telecom, and those are two very interesting sectors these days. We identify big macro-themes and we look for where there are shifts in an industry."
Its performance can swing significantly: It was down more than 26 percent in 2015 and up more than 30 percent the next year. Over the past 10-year period, it has beaten the Barclays Agg, but trailed the Morningstar high-yield category average.
Ascendant Tactical Yield Fund (ATYAX)
One-year return: 5.7 percent
Co-manager Porter Landreth said the most reliable trend in the marketplace right now is rising short-term interest rates in the U.S., so its safest positions are in adjustable and floating rate instruments. The fund invests 75 percent of its assets in adjustable-rate mortgage bonds and 25 percent in floating-rate bonds.
Landreth said there is tremendous value in adjustable-rate mortgage bonds. "Only the quality bonds are left in those tranches that were forced to be dumped during the financial crisis."
Fundamentals are strong for these securities as real estate value across the country are up and collateral has greatly improved from the crisis period, Landreth said. As a result, these mortgage bonds "may be higher quality than they appear."
The fund has beaten the nontraditional bond category average and Barclays Agg return in the year-to-date, one-year and three-year periods, according to Morningstar.
Nationwide Amundi Strategic Income Fund (NWXEX)
One-year return: 5.2 percent
Co-manager Jonathan Duensing said the fund invests across market sectors, across maturities, and while being U.S.- focused, will invest outside the U.S. to gain some global exposure. Varying the duration of bonds has made the fund less sensitive to interest-rate movement.
Right now, like other successful funds, Duensing is finding opportunities in the securitized credit market. Consumer balance sheets are in good shape and housing is in demand, so fundamentals are strong. "From a valuation standpoint, the securitized credit market versus the corporate bond market, the valuations are absolutely compelling," he said.
The fund has beaten both the Barclays Agg and its bond category year-to-date and in the past year, though Morningstar classifies it as a multi-sector bond fund rather than unconstrained bond fund. The major differences: multi-sector managers tend to stay within a preferred group of bond areas to invest, whereas unconstrained managers tend to make tactical shifts more frequently and focus more on interest-rate risk.
Putnam Diversified Income Trust (PDINX)
One-year return: 4.8 percent
Portfolio co-manager Bill Kohli said minimizing interest-rate risk has been key to his fund's success. He said the Putnam Diversified Income Trust starts at a duration of zero and then mixes bonds of different durations to minimize exposure to the Fed's interest rate moves.
Like Ascendant, a focus on securitized bonds, such as mortgages, that took a beating in the financial crisis, has been a key to performance. "Many market participants have either been regulated out of the market or management deemphasizes those areas where they got their fingers burnt," Kohli said. "So if you're an investor or fund manager you're getting paid an attractive premium to move into the space because the market hasn't healed yet. The spreads you are getting are not representative of fundamental loss risk."
This Putnam fund has generated its biggest performance edge against both the nontraditional bond fund category average and Barclays Agg in the past year, but has maintained a more narrow outperformance over the long-term.
Braddock Multi-Strategy Income Fund (BDKAX)
One-year return: 4.8 percent
Co-manager Garrett Tripp said the keys to his fund's success are two-fold: the fund uses a floating-rate strategy for the rising interest-rate environment, and the managers focus on structured finance. It invests primarily in high yield asset-backed debt securities, residential mortgage-backed securities and collateralized loan obligations.
Tripp said after the housing crisis, underwriting standards tightened which led to better credit markets and builders retrenching, causing a shortage of supply in entry-level homes. "This will keep housing prices from falling," Tripp said. "We'll have high recovery rates in our RMBS even if someone wants to default."
Dodd-Frank reform has also made structured finance more regulated, driving up the quality of the bonds.
The fund has beaten both the Barclays Agg and its category average year-to-date and in the past year, though like the Nationwide Amundi Strategic Income Fund, Morningstar classifies it as a multi-sector bond fund rather than unconstrained bond fund.