How bond holders could handle interest rate risk
Over the past few years, some of the most promising fixed income products follow an unconstrained style where portfolio managers use their skills to beat the index and are allowed to invest almost anywhere. The motive behind the style is to give managers a chance to invest “outside the box.” Some of the most popular unconstrained bonds are:
- BlackRock Strategic Income Opps Inv A (BASIX)
- Janus Unconstrained Bond A (JUCAX)
- Goldman Sachs Strategic Income A (GSZAX)
- JPMorgan Strategic Income Opportunites A (JSOAX)
The graph below shows the monthly performance of BASIX, GSZAX, and Barclays US Aggregate Bond Index.
Why unconstrained funds are popular
The prime reason for the increasing popularity of this category is the low interest rate environment. Low interest rates often encourage investors to purchase debts and invest in emerging market bonds. The risk of an increase in interest rate is mitigated as unrestricted bonds are not restricted to any index and can change their holdings as required. Unrestricted funds have become quite popular, but they do come with drawbacks:
- The focus is on return generation rather than mimicking the benchmark, which can cause the investment manager to take unnecessary risks to generate returns.
- It’s difficult to compare the performance of each manager.
- A standardized benchmark isn’t available, so it is difficult to evaluate the performance of the manager.
An interest rate hike might increase unrestricted bond funds
Barclays Capital Aggregate Bond Index is one of the most widely tracked fixed income indexes. Almost 70% of the index is made up of US Treasuries and agency bonds, which makes it sensitive to interest rate increases. If the Fed plans to increase the interest rate even by 1%, investors in funds that track Barclays Aggregate could suffer huge principal losses, which might open the road to unrestricted bond investors. Unrestricted bond investors have suffered an average loss of 0.3% compared to the Barclays Aggregate’s 0.4% gain due to continued low interest rates.
Looking into the holdings of the Basix fund, real estate contributes 12.1% of the total weight. If the Fed raises the interest rates, the manager may change the composition in order to benefit from the changing scenario.
An increase in interest rates can be a cause of concern for funds like the iShares US Real Estate ETF (IYR) and for securities like Annaly Capital Management (NLY), American Capital Agency (AGNC), and Starwood Property Trust (STWD), which hold significant weight in IYR and the iShares Mortgage Real Estate Capped ETF (REM).