NEW YORK (TheStreet) -- Worried about rising interest rates, investors have been pouring into unconstrained bond funds, a new kind of fixed-income investment. While traditional bond funds tend to decline when interest rates climb, the unconstrained portfolios can be resilient in difficult markets.
Among the most popular choices is
PIMCO Unconstrained Bond
, which began operating in 2008 and already has $15.9 billion in assets, according to Morningstar. Other large funds are
JPMorgan Strategic Income Opportunities
, with $13.6 billion, and
Eaton Vance Global Macro Absolute Return
, with $7.6 billion.
The funds aim to make money in nearly every kind of market. To do that, they use a wide range of strategies, including holding U.S. and foreign bonds. The portfolio managers can sell short, betting that bonds will fall. The funds have appealed to financial advisors who figure that rates will rise as the economy strengthens and borrowers compete for loans. Some advisors fear that interest rates could climb for years as Washington continues juicing the economy by running big budget deficits.
The unconstrained bond funds got an early test in the fourth quarter of 2010. During that period, the yield on 10-year Treasuries rose from 2.54% to 3.30%, and intermediate-term bonds funds dropped 0.9%. Some unconstrained funds sailed through the difficult period, protecting shareholders. JPMorgan Strategic Income Opportunities returned 1.9% for the quarter, while Eaton Vance Global Macro Absolute Return returned 0.4%.
The unconstrained bond funds are likely to become even more popular when the Federal Reserve eventually begins raising rates. Should you rush and put all your fixed-income holdings in the new funds? Probably not. Many economists think that the Fed will not raise rates for the next year, and it is possible that rates may drop in coming months. If that happens, traditional portfolio managers could outdo unconstrained competitors that sell bonds short.
Because of the uncertainty, the best approach is to maintain a diversified bond portfolio that includes of mix of traditional investment-grade funds, along with some lower-quality issues. Investors who want extra diversification could put a small percentage of assets into funds that sell short and use unconventional strategies.
Cautious investors might consider JPMorgan Strategic Income Opportunities. The fund aims to outdo Treasury bills every year by more than 2 percentage points. To accomplish the goal, portfolio manager William Eigen moves opportunistically, emphasizing junk bonds one year and cash the next. Eigen figures that interest rates will rise over the next couple years. To prepare for difficult bond markets, the fund currently has 62% of its assets in cash or securities with maturities of less than 1 year. The mix of cash and short securities could enable the fund to stay in the black if rates rise. "If we can't find intelligent things to do with capital, we go to cash," says Eigen.
When bond markets froze in the fourth quarter of 2008, the JPMorgan fund scooped up high-yield bonds, which had sunk to big discounts as investors worried about the economy slipping into a depression. In 2009, high-yield bonds rallied sharply, and Eigen scored big gains. Since then the fund has lightened its high-yield positions and begun selling bonds short.
Another fund that should hold up in bear markets is
Eaton Vance Strategic Income
. During the difficult fourth quarter of 2010, the fund returned 1.5%.
Traditional strategic income funds hold broadly diversified portfolios that include at least three assets, high-yield bonds, government issues, and foreign securities. The Eaton Vance fund has the usual assets. But in the addition, the fund has part of its portfolio in a global macro strategy. This flexible strategy aims to produce consistent results by selling short and owning foreign currencies.
Eaton Vance portfolio manager Eric Stein worries that Washington's budget deficits will cause the dollar to weaken. For protection, he has one-third of his assets in foreign bonds, including local issues from Brazil, which could appreciate against the dollar. To shield shareholders from rising interest rates, Stein has 20% of assets in floating rate loans. When interest rates rise, the yields on the loans increase. That enables the loans to produce solid returns when many bonds are sinking.
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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.