How to advise on unconstrained fixed income

The eVestment global unconstrained fixed-income universe has grown from around $92bn in 2009 to close to $500bn by the end of 2015, invested across 125 different manager products. 

How to incorporate into portfolios

To date the performance of many unconstrained fixed income products has been mixed, benefiting initially from an environment of stable credit spreads and declining interest rates during 2009-13 but have then struggled since the anticipated rise in interest rates has taken far longer than expected to materialise.

However, as the Federal Reserve looks set to raise interest rates again it may be timely for investors to incorporate an unconstrained bond strategy in their portfolios.

Low yields suggest low future returns and hold the potential for negative returns if yields rise unexpectedly. This has seen investors allocating to unconstrained fixed-income products to complement either their traditional, index-based products or liability-matching solutions.

So-called unconstrained products offer more diverse sources of return and, by allowing managers greater freedom to diverge from the index, may overcome some of the weaknesses of traditional market capitalisation-weighted indices.

There’s little consistency in the way these products are categorised, producing confusion among investors and muddling the process of assessing and selecting managers.

The problem is that unconstrained fixed-income products come in many guises and are described variously as multi-sector fixed-income, absolute return, total return, strategic bond, multi-asset credit and other, more niche, strategies involving asset-backed securities and forms of illiquid credit. 

These products may all be unconstrained, but they have little else in common and the investment processes tend to be manager-specific. There’s little consistency in the way these products are categorised, producing confusion among investors and muddling the process of assessing and selecting managers.  

Understanding the key characteristics of these different products and how they’re implemented is arguably more important than their categorisation as ‘unconstrained’.

The best approach for investors looking to allocate to unconstrained fixed income is to work closely with their asset manager and implement strategies that meet their specific expectations and objectives, rather than to buy an off-the-shelf product.

Alternative strategy

Institutional investors typically use fixed income strategies either as an alternative to equities or for liability matching. Bond indices have played a critical role in affecting these asset allocation decisions, as they’ve provided investors with a proxy for the risk-and-return characteristics of the underlying bond asset classes. 

Examples of these indices include the FTSE Actuaries UK Gilts or JP Morgan Bond indices, which are market capitalisation-weighted, investment-grade indices. 

By selecting one of these indices as a benchmark, the investor is setting the starting point for managers to take active positions, reflecting their views on relative value in bond markets.