NEW YORK ( TheStreet) -- Like many investors, bond giant PIMCO has become concerned that interest rates will rise. If that happens, bond prices could fall, and many fixed-income funds could sink into the red. A market decline could hurt even PIMCO Total Return ( PTTDX), the top-performing fund run by bond guru Bill Gross.What can investors do for protection? Try PIMCO Unconstrained Bond ( PUBDX). As its name suggests, the fund can use a variety of strategies, including selling bonds short, to achieve gains when rates rise. Both PIMCO Unconstrained and PIMCO Total Return rely on thorough research. Led by Bill Gross, the researchers make regular forecasts -- and the funds invest accordingly. But PIMCO Total Return has strict limitations. It can only put 30% of assets in foreign securities and 10% in high-yield bonds, which are rated below-investment grade. PIMCO Unconstrained can put as much as it wants in foreign securities and 40% of its assets in high-yield bonds. Because of its flexibility, the unconstrained fund has the potential to produce greater returns over the long term. These days, the PIMCO team is especially worried about rising rates. To finance the huge budget deficit, the government is issuing a flood of Treasury bonds. The excess supplies should result in bond prices falling and interest rates rising, says Chris Dialynas, portfolio manager of PIMCO Unconstrained. So far, rates have remained in check, because the Federal Reserve has been buying bonds as part of its quantitative easing program. But the Fed's purchases will likely end soon. When that happens, supplies will swamp demand and prices will fall, says Dialynas. To limit the damage from rising rates, bond portfolio managers often hold securities with short maturities. Those tend to suffer limited losses in market declines. While the PIMCO managers are emphasizing shorter bonds, the unconstrained fund is free to take more decisive measures. To appreciate the strategies of both funds, consider duration, a measure of interest rate sensitivity. The duration of the Barclays Capital Aggregate Bond index is 4.5 years. So if interest rates rise by 1 percentage point, the benchmark would lose roughly 4.5%. By prospectus, PIMCO Total Return must keep its duration within 2 percentage points of the index. Bill Gross normally stays close to the benchmark. But because he is convinced that rates will rise, Gross has shortened his duration to only 3.6 years. That is one of his biggest deviations from the benchmark ever.
PIMCO Unconstrained has more leeway to maneuver. Late in 2010, the fund lowered its duration close to zero. So if rates rise, the fund may not suffer any losses. This year, rates have fallen a bit. That has penalized the unconstrained fund. "We were too early," says portfolio manager Chris Dialynas. "We would have been better off if we didn't reduce the duration to zero." So far this year, the unconstrained fund has returned 1.1%, trailing the PIMCO Total Return at 3.0%. The Barclays benchmark has returned 2.7%. Not all the strategies of PIMCO Unconstrained have failed. Convinced that bank balance sheets are improving, the fund has been holding bonds from financial companies. That has helped to boost returns. The fund also scored gains with taxable municipal bonds from California. Despite the mixed showing of PIMCO Unconstrained, investors have poured into the fund. The portfolio has $16 billion in assets, a big showing for a fund that launched less than three years ago. Investors have turned to the fund because they seek protection from rising rates. No-Load Fund Analyst, a respected newsletter, recommends that investors own both PIMCO Unconstrained and PIMCO Total Return. The newsletter argues that the unconstrained fund should deliver strong returns because it represents PIMCO's best thinking -- without benchmark restraints. If the unconstrained fund is so versatile, why bother with PIMCO Total Return? The newsletter says that holding the two funds together provides some diversification. If the economy suffers a shock and interest rates sink, PIMCO Total Return could provide positive returns. The relatively staid approach of the flagship PIMCO fund could provide the ballast that many portfolios need.
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