Most unconstrained bond funds are failing to embrace the full opportunity set offered to them and are instead tethering themselves to certain assets by their need to deliver on a yield target, according to Reams Unconstrained Bond co-manager Todd Thompson.
There was a boom in popularity of unconstrained bond funds in the aftermath of the 2007 global financial crisis, as they can, in theory, invest in a wide range of debt instruments across different sectors, countries or currencies.
However, Thompson claimed while some may perpetuate themselves as unconstrained, in reality, a lot may have static allocations and are tethered to certain securities. “It was in vogue to become an unconstrained fund, and in my opinion there’s a lot of income funds cloaked in unconstrained clothing,” he said.
The manager argued that the $901.7m Reams Unconstrained Bond fund can be truly unconstrained and pursues value opportunities throughout all sectors of the fixed income market.
As well as reacting to opportunities, the fund takes advantage of volatility, rather than relying on economic forecasting and predicting market movements. This unconstrained approach allows the fund to add value in niche parts of the market overlooked by other managers.
“It used to be that you were charged with using all the arrows in the quiver to extract value and go to where value is to beat the benchmark,” Thompson said.
“Our thinking was to be more benchmark agnostic, wherein you could untether yourself and use creativity to go where that value is.”
Thompson said the success of the unconstrained philosophy is twofold: the first relies on a longer time horizon which can be difficult when investors are chasing quarterly returns, while the second element is a steer away from absolute yield and towards total return.
“There’s too much focus on absolute yield in the bond world,” he said. “When you focus on the total rate of return prospect, the income takes care of itself.”
The manager added that the essence of an unconstrained approach also lies in remaining opportunistic.
“Let me wait for those opportunities to happen and then go to where that value is,” he noted. “It might be in emerging market debt, high yield or sovereign bonds – and that’s just a different mindset from an income fund.”
Low correlation of fund with traditional benchmarks
Source: Reams Asset Management
Indeed, Thompson said 2020 had been a great indicator to decipher the income from the unconstrained - based on how they react to certain events.
“Last year was a classic example, when spreads widened, the wherewithal to pivot just wasn’t there and a lot of firms were almost paralysed by being long-risk and not having the flexibility to respond to a generational widening of spreads,” he claimed.
While the fund’s unconstrained peers were wedded to certain allocations, Thompson said Reams Unconstrained Bond concentrated on the total return opportunities – a belief the fund has had since its inception.
“We’ve always steered by that compass,” he said. “As long as we focus on value and total rate of return, the income takes care of itself.”
The fund uses deterministic modelling as its main guardrail when analysing the different outcomes that could affect its position in a security.
“You can make Draconian assumptions on what could go wrong,” Thompson added. “What is the market not thinking about and what are the tail risks that haven’t been factored in?”
For this reason, the fund went through the global financial crisis without owning any subprime bonds as they didn’t meet the required filters.
This approach is in contrast with others who favour probabilistic models, something Thompson explained is not conducive to a fixed income portfolio.
“They are inherently backward-looking across spreads, correlation and volatility,” he said. “The problem with backward-looking tools is they can give you a false buy signal. They are almost risk-budgeting type models and are fraught with giving those indications.
“We prefer deterministic modelling which will give us the appropriate downside risks and a comfort level before we enter a security.”
Performance of fund vs sector over 3yrs
Source: FE Analytics
Over three years, Reams Unconstrained Bond has made a total return of 24.26 per cent while the average fund in the FO Fixed Int – Global sector has made 12.98 per cent.
The threat of inflation has been well documented, but especially in the US, which has been exacerbated by the large-scale stimulus package that president Joe Biden signed into law earlier this year.
“The tail risk has gone up considerably in the last year, with the fiscal stimulus we’ve had so far and what is likely to happen in the future,” he said. “It’s very unknown and the risks are high.”
He argued that, as the US hasn’t seen fiscal stimulus for 10 years, the combination with monetary stimulus has an unpredictable outcome.
“Could this toxic brew create an explosion? We don’t know,” he said.
A lot has been made in recent months of the pent-up consumer demand and this according to Thompson may create a “firestorm” of inflation.
“The market is saying this is going to be a short burst then dissipate,” he added.
However, he argued that the mitigant against this would be the level of government and corporate debt issued throughout the pandemic.
“We have not operated with this level of debt in history and it could act as a suffocating mechanism to suppress inflation,” he finished.
“Having said that, these extreme tail risks should be priced in. Why is the market so quiescent about this? It could be a very dicey outcome.”
Performance of fund vs sector over 7yrs
Source: FE Analytics
Over a longer market cycle, the five FE fundinfo Crown Rated fund made a total return of 49.81 per cent while the FO Fixed Int – Global sector peer made 36.33 per cent.