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Allocation Question regarding Unconstrained Bond Funds.
What percentage of a bond portfolio could be allocated to strategic/Unconstrained bond funds? This is a personal question as I consider my allocation going forward in retirement.
I think at least 50% of ones bond holdings should be indexed to core holdings like Vanguard total bond Once that is taken care of the issue is how you should invest because the bond market looks challenging. I see two possibilities First consider deciding how much to invest in high yield , international bonds, emerging markets , short term bonds etc. The trouble with this is a multiplicity of funds which makes it hard to rebalance and monitor but also your allocation will be based on your own knowledge which might or might not be better than Gundlach, Gross, Fuss etc. A reasonable alternative is to pick one of the Gurus for the 50% going to strategic. Which one? : I would go with the smallest fund you can fund headed by a manager you respect.You could also use expense ratio as a major criteria,
I would be cautious about owning core bond funds when we are in a period of rising interest rates. Flat-to-lower rates are ideal for core bonds, but when times are less sure, hiring experienced, unconstrained bond managers seems to make sense. Even in times when core bonds should shine, some unconstrained managers out-perform. Consider Carl Kaufman, Dan Fuss/Elaine Stokes/Matt Eagon, Kathleen Gaffney, Jason Brady, and others. This does not mean unconstrained funds won't have a bad year along the way. Most investors have never experienced a long period of rising interest rates, and will find out the hard way that some core funds (and some unconstrained funds, too) will be sorely tested in the years ahead. Then again, the definition of what a core bond fund is. VBMFX, for example, has not lived through a period of rising rates. It has been stellar in the past, but none of us knows what will happen. Duration is one way to measure potential risk, with this fund having a probability of losing 5.6% of its value for every 1% increase in interest rates. If that is something one can live with, ok. But I would much rather reduce overall risk by owning a group of actively-managed, non-core funds. Different strokes for different folks.
Duration was one of the factors I went into ASDVX. It's a new fund but American Century brought in Marge Karner who is not as well known as Gundlach or Fuss but nonetheless has experience. She heads a team of four other managers. Currently the duration is 1.9 years. There is another fund with the same concept, ASIEX and that one has a duration of 4 years.
I do like these unconstrained bond funds but as with most questions, you will get differing answers. It depends on the funds themselves. This is new territory we are heading into so who knows what will happen.
I would be cautious about owning core bond funds when we are in a period of rising interest rates. Flat-to-lower rates are ideal for core bonds, ... Then again, the definition of what a core bond fund is. VBMFX, for example, has not lived through a period of rising rates. It has been stellar in the past, but none of us knows what will happen.
Bob, I think you might be a bit too literal here. While John (and jerry) referred to "core bond", they (or at least John) were speaking in terms of their portfolio (i.e. their "main" or "anchor" holding), and not literally in terms of the type of fund ("core bond fund").
ACCNX is a core plus fund - it can hold junk bonds and vary the portfolio attributes considerably. According to M*, it went big into junk this year, now sporting an average credit rating of BB. Further, nearly half its bonds are securitized (generally MBS) vs. a quarter for its typical peer, placing it about midway between DLTNX and VBMFX.
While I'm not necessarily advocating ACCNX (don't know enough about it), I do think that core plus funds (with the right managers) can serve one well even in this environment.
Duration is one way to measure potential risk, with this fund having a probability of losing 5.6% of its value for every 1% increase in interest rates.
This brings us to another point, and one which makes me less sanguine about funds that tilt toward MBSs.
A duration of 5.6 years means that if interest rates go up by a basis point, then the portfolio may expect to lose 5.6 basis points. But the next basis point in rate change will (usually) bring a lesser shift in NAV. That's because the price/yield curve is concave up (like a y=1/x curve) - equivalently, that it has positive convexity, or its second derivative is positive. So the further you go out on the curve (the higher rates go), the shallower the slope, and the less the price changes for each additional basis point of interest.
But MBSs are different. They can even have negative convexity, meaning that the higher rates go, the faster the NAV changes. MBSs tend to be good in a slowly changing interest rate environment (as we seem to have now), but can misbehave when rates change quickly.
Just another reason why choice of managers is important, and why even core plus bond funds have a lot flexibility that they can use to good advantage or to hang themselves.
@msf, I'll take the blame here. I forgot that it is Core Plus, the term AC used for funds that have extended capabilities. This fund is my biggest bond holding so I suppose that makes it my core holding. I do have a good amount in AOMIX which has several bond funds in it but not this one.
No blame - just trying to clarify. I thought your meaning was clear, but BobC's reference to VBMFX suggested that he was reading it differently.
VBMFX is particularly egregious - even Bogle is critical of its slavish devotion to the "wrong" index. (Total bond indexes "are deeply flawed - and that's coming from an indexer.")
I would be cautious about owning core bond funds when we are in a period of rising interest rates. Flat-to-lower rates are ideal for core bonds, but when times are less sure, hiring experienced, unconstrained bond managers seems to make sense.
I have no idea what will happen to interest rates and the bond market, whether we will get Bill Gross' "new neutral" of a 2% Federal Funds rate or what the Fed thinks will be a 3.75% neutral policy rate by the end of 2017....and no idea what will happen to the US and world economies
People like David Swensen who runs the Yale endowment and wrote the book Unconventional Success, A Fundamental Approach to Personal Investment, strongly believe that we should only hold the highest quality bonds, Treasuries (both nominal and TIPS). Larry Swedroe also recommends only ultra high quality bonds. Swensen's reasoning is that bonds should play a very specific role in your portfolio, that of diversifying equity risk, especially for when equities go down. Take a look at how Treasuries performed in 2008 versus junk bonds, bank loans, and almost all bonds besides Treasuries.
The unconstrained bond funds generally have reduced average maturities, reduced duration. In many cases very significantly so. In exchange for the reduced interest rate risk, you generally get a very substantially increased credit risk. A significantly reduced quality of the bonds.
You mentioned great managers above, who manage great funds. If the economy continues to recover, unemployment continues to decrease and eventually wages rise, etc, I'm sure the unconstrained bond funds in aggregate will do much better than the total bond market index funds like BND and AGG. And far better than Treasury bond funds. Taking credit risk instead of interest rate risk would be a good move if that plays out. But in the event that the economy and the stock market do poorly, the Treasury bond funds and total bond market funds should outperform the unconstrained funds in aggregate. This can be seen clearly in days like today, and other recent days when the stock market has done badly. Treasuries have done very well, and the total bond market funds have done fine also. They have diversified the portfolio just at the right time, when stocks did badly. Unconstrained bond funds, junk bond funds and lower quality bond funds have not diversified the portfolio that well at these times.
That's why Swensen and Swedroe only recommend the highest quality bonds, for portfolio diversification in the event that stocks or the economy do badly. Sort of as an insurance policy.
However, I can certainly see the great value in giving fixed income money to the managers named above and letting them invest it in an "unconstrained" manner, as they see best. JMO.
I can see where unconstrained bond funds would have trouble selling the junk bonds to buy higher quality if nobody wants junk. The timing of the manager would be key.
I have enjoyed listening to Larry Swedroe when interviewed. His comment of having quality bonds has some weight. I have a fund on my watch list that is short duration (2 yrs) and AAA average rating holding treasuries and other govt bonds.
My core holding ACCNX currently has a BBB average rating now. Duration is 4.8 yrs. I'll have to watch this to see if that will improve in the coming months.
Many of these bond funds have added high yield and other bonds to increase returns. They are straying off the path a bit from what they were originally intended. Just like the utilities funds with telecoms and other industries that suddenly became utilities. It will be interesting to see if these funds adjust back to their original intent when things get tough.
Thanks all for an interesting discussion -- themes that have been on my mind too. My main bond holding has been SUBFX -- an uncontrained bond fund well-prepared for rising interest rates that have yet to come. In retrospect that wasn't a great choice to diversify an equity-heavy portfolio, since at this stage rising interest rates would come from an improving economy, so my stocks should go up too; but I think it's now too late to move into something like EDV, so I'm holding.
From Barron's blog, a nice summary of YTD action in bonds - remember the talking heads predicting 'nowhere to go but up' when the 10y hit 3%?
Like expatsp said, choice of bonds depends hugely on what else is in the portfolio, and the last few days are a reminder of why IG bonds work well in a portfolio with significant equity.
It's also 'educational' to see what HY is doing vs. equity lately - despite the fear of non-IG bonds (also expressed in the Barron's blog time after time), they're behaving as advertised: running in the same direction as equity, but with less upside/downside.
Hey John - IG = investment grade, AAA-BBB credit rating, the zone that's generally more affected by rate changes, and whose prices typically run in the opposite direction from stocks.
So what I gather from all this good information is that some like high quality bonds, some like the unconstrained bond funds, and I would suppose some would go with both. maybe a mix of those plus some hedged or market neutral type funds?
Comments
A reasonable alternative is to pick one of the Gurus for the 50% going to strategic. Which one? : I would go with the smallest fund you can fund headed by a manager you respect.You could also use expense ratio as a major criteria,
I do like these unconstrained bond funds but as with most questions, you will get differing answers. It depends on the funds themselves. This is new territory we are heading into so who knows what will happen.
Thanks @jerry and @BobC for your responses.
ACCNX is a core plus fund - it can hold junk bonds and vary the portfolio attributes considerably. According to M*, it went big into junk this year, now sporting an average credit rating of BB. Further, nearly half its bonds are securitized (generally MBS) vs. a quarter for its typical peer, placing it about midway between DLTNX and VBMFX.
While I'm not necessarily advocating ACCNX (don't know enough about it), I do think that core plus funds (with the right managers) can serve one well even in this environment. This brings us to another point, and one which makes me less sanguine about funds that tilt toward MBSs.
A duration of 5.6 years means that if interest rates go up by a basis point, then the portfolio may expect to lose 5.6 basis points. But the next basis point in rate change will (usually) bring a lesser shift in NAV. That's because the price/yield curve is concave up (like a y=1/x curve) - equivalently, that it has positive convexity, or its second derivative is positive. So the further you go out on the curve (the higher rates go), the shallower the slope, and the less the price changes for each additional basis point of interest.
But MBSs are different. They can even have negative convexity, meaning that the higher rates go, the faster the NAV changes. MBSs tend to be good in a slowly changing interest rate environment (as we seem to have now), but can misbehave when rates change quickly.
Just another reason why choice of managers is important, and why even core plus bond funds have a lot flexibility that they can use to good advantage or to hang themselves.
VBMFX is particularly egregious - even Bogle is critical of its slavish devotion to the "wrong" index. (Total bond indexes "are deeply flawed - and that's coming from an indexer.")
People like David Swensen who runs the Yale endowment and wrote the book Unconventional Success, A Fundamental Approach to Personal Investment, strongly believe that we should only hold the highest quality bonds, Treasuries (both nominal and TIPS). Larry Swedroe also recommends only ultra high quality bonds. Swensen's reasoning is that bonds should play a very specific role in your portfolio, that of diversifying equity risk, especially for when equities go down. Take a look at how Treasuries performed in 2008 versus junk bonds, bank loans, and almost all bonds besides Treasuries.
The unconstrained bond funds generally have reduced average maturities, reduced duration. In many cases very significantly so. In exchange for the reduced interest rate risk, you generally get a very substantially increased credit risk. A significantly reduced quality of the bonds.
You mentioned great managers above, who manage great funds.
If the economy continues to recover, unemployment continues to decrease and eventually wages rise, etc, I'm sure the unconstrained bond funds in aggregate will do much better than the total bond market index funds like BND and AGG. And far better than Treasury bond funds. Taking credit risk instead of interest rate risk would be a good move if that plays out. But in the event that the economy and the stock market do poorly, the Treasury bond funds and total bond market funds should outperform the unconstrained funds in aggregate. This can be seen clearly in days like today, and other recent days when the stock market has done badly. Treasuries have done very well, and the total bond market funds have done fine also. They have diversified the portfolio just at the right time, when stocks did badly. Unconstrained bond funds, junk bond funds and lower quality bond funds have not diversified the portfolio that well at these times.
That's why Swensen and Swedroe only recommend the highest quality bonds, for portfolio diversification in the event that stocks or the economy do badly. Sort of as an insurance policy.
However, I can certainly see the great value in giving fixed income money to the managers named above and letting them invest it in an "unconstrained" manner, as they see best. JMO.
I have enjoyed listening to Larry Swedroe when interviewed. His comment of having quality bonds has some weight. I have a fund on my watch list that is short duration (2 yrs) and AAA average rating holding treasuries and other govt bonds.
My core holding ACCNX currently has a BBB average rating now. Duration is 4.8 yrs. I'll have to watch this to see if that will improve in the coming months.
Many of these bond funds have added high yield and other bonds to increase returns. They are straying off the path a bit from what they were originally intended. Just like the utilities funds with telecoms and other industries that suddenly became utilities. It will be interesting to see if these funds adjust back to their original intent when things get tough.
Like expatsp said, choice of bonds depends hugely on what else is in the portfolio, and the last few days are a reminder of why IG bonds work well in a portfolio with significant equity.
It's also 'educational' to see what HY is doing vs. equity lately - despite the fear of non-IG bonds (also expressed in the Barron's blog time after time), they're behaving as advertised: running in the same direction as equity, but with less upside/downside.