Investing for Retirement: Pros and Cons of Unconstrained Bond Funds

Amid the recent rout in Italian markets, Bill Gross's Janus Henderson Global Unconstrained Bond fund JUCIX briefly fell by more than 3%. That might give income investors pause when it comes to owning or buying unconstrained bond funds.

But the precipitous drop in Gross's fund was a bit of an aberration. By contrast, unconstrained bond funds were down, on average, just 0.2% year-to-date as of last week.

What happened? Well, according to a story in the Wall Street Journal, Gross made a wrong bet; he bet German bond prices would fall along with Italian bond prices -- but they didn't.

What do you need to know about unconstrained bond funds?

The most important aspect for investors to understand is that the risks associated with unconstrained bond funds are substantially higher than traditional core bond funds, says Vincent Colubiale, president of FinTech Wealth Management.

"While both are diversified in fixed income, unconstrained bond funds tend to a carry higher concentration of foreign securities and currencies, which can be quite volatile, as we have seen recently," he says.

These risks in foreign securities, as stated in the Janus Henderson Global Unconstrained Bond fund prospectus, "may involve more risks than domestic transactions, including currency risk, counterparty risk, political and economic risk, regulatory risk and equity risk. Risks may arise from unanticipated movements in the value of foreign currencies relative to the U.S. dollar."

Further, Colubiale says, investors and money managers must go beyond glancing at the asset allocation statistics in Morningstar and actually read the prospectus. For instance, the Janus Henderson Global Unconstrained Bond fund allocated 34.02% to cash as of March 31, 2018.

"The retail investor may glance at this and view it as a 'safer' bond fund given the elevated levels of cash held in the fund," says Colubiale. "However, when you dig into the prospectus, you will find that over 17% of the fund's total assets are held in a foreign currency and 22.8% of total assets either have no rating or are classified as 'other.'"

Fixed-income funds are highly subject to credit risks. Given that, it's important for investors to understand that the percentage of securities that are A-rated or better in the Janus Henderson Global Unconstrained Bond fund composes only 12.56% of the fund, says Colubiale. "This is a low credit quality fund," he says. "These lower credit quality fixed-income securities tend to trade the same way as equities during times of equity market stress."

Buyer Beware

Over the past decade the Fed, ECB, BOJ, and PBOC have expanded their balance sheets by over $14 trillion dollars, says Colubiale. "This may have inflated world asset prices, and deeply suppressed yields around the globe to artificially low levels," he says.

"As these Central Banks unwind assets in the decades to follow, this could potentially be a major headwind for world fixed income and risk assets. This elephant in the room will be here for a long time."

Pros: That buyer beware duly noted, Colubiale says unconstrained bond funds give investors access to foreign currency and credit markets which tend to be a difficult asset class for retail investors to diversity a portion of their portfolio with individual securities. "This would not be recommended as a core bond holding in a diversified portfolio. However, if an investor is comfortable with the higher risks associated with these funds to diversify a fixed-income portfolio, 3% of an investor's allocation to fixed income may be a good starting point as a potential investment," he says.

Cons: That said, the performance of these funds over the past four years has been dismal, with the Janus Henderson Global Unconstrained Bond Fund averaging less than 1% per year, says Colubiale. "Currently, five-year CDs are yielding over 3%," he says.

Given the potential headwinds that fixed-income securities face in the years to come due to prolonged Central Bank interventions, Colubiale says caution is warranted. "Sometimes, investing in a simple and straightforward fixed-rate investment, that one fully understands, is the best course of action to take during times of high uncertainty," he says.

Other Resources on Unconstrained Bond Funds:

Picking the Right Unconstrained Bond Fund Matters - Morningstar

Fund Analyst View: Have Unconstrained Bond Funds ... - Morningstar