April and May’s testing of the symbolic 3% yield threshold for 10-year Treasuries triggered a wave of headlines cautioning against fixed income mutual fund losses. And, for the most part, those concerns were warranted. The Bloomberg Barclays U.S. Aggregate Bond Index, fell almost -3% year to date in May, but rallied to end up down only -1.85% for the year as of June 1st.
There’s one group of bond funds, however, whose investors are more than happy to see the Fed’s rising rates regime finally hit its stride: non-traditional bond funds. These funds have seen a significant uptick in performance since we last wrote about them in 2015.
After years of underperformance following the financial crisis, this segment has been outperforming the broader market index this year. Many non-traditional bond funds had positioned their portfolios years ago to take advantage of rising rates following the Federal Reserve’s move to lower rates to near zero in 2008. A common strategy employed by those funds was to short Treasury futures and invest in floating rate instruments. With interest rates at historical lows, this seemed to be an intuitive strategy.
The premise was a solid one, but what the market didn’t anticipate was how long the Fed would leave rates at that near-zero level or how low inflation would remain during that time. As we know, rates were left alone from 2008 until the last quarter of 2015. Not surprisingly, non-traditional performance suffered relative to the overall bond market, which led to criticism of the fund segment due to their higher fees relative to core bond mutual funds.
But non-traditional bond funds’ fortunes began to reverse following the Fed’s December 2015 meeting, and their performance has strengthened as the Fed has demonstrated its commitment to multiple hikes.
Fast-forward to this year, when looking at the combined returns of the five highest performing non-traditional bond funds year to date1 using Dynamic Style Analysis (DSA), MPI’s proprietary factor model,2 we can see much of their exposures appear to be designed to benefit from, or be neutral to, rising interest rates, chiefly by exhibiting short exposure to Treasuries and by exhibiting long exposure to floating rate ABS and leveraged loans, which are also floating rate. As a comparison, we also analyzed the five largest funds as of April 30, 2018.3
Looking over the past 24 months, during which rates have steadily risen, these strategies appear to have paid off. This is evident from the below chart, which compares the average excess performance of the top five performing non-traditional bond funds, as well as the average excess performance of the five largest funds, to the Bloomberg Barclays U.S. Aggregate Bond Index. It also attributes performance based on over/under-weighting of exposures versus the overall bond market.4
One can see that compared to the largest funds, the best five performing funds show higher attribution to exposures less affected by rising interest rates (Floating Rate ABS, MBS and Leveraged Loans). The larger selection return indicates that there have been positive returns that cannot be explained by market exposures. It could also indicate other investments not captured by the factors used, benefits from security selection or better hedging.
As investors are routinely warned, looking at recent performance may not be indicative of future results. This is especially the case when dealing with funds with shorter histories and newer strategies. That said, between 2010 and 2015, many investors could have dismissed non-traditional bond funds as a high-priced gimmick, delivering no benefit over traditional core bond funds. As the economy recovers and interest rates rise, however, these funds look to have been well-positioned to benefit, helping them to outperform since 2015.
Footnotes
- 1Top five performing mutual funds in Morningstar’s Non-Traditional Bond category YTD 2018 through May are: 1. Columbia Mortgage Opportunities Inst2; 2. Putnam Mortgage Opportunities I; 3. Semper MBS Total Return Institutional; 4. PIMCO Unconstrained Tax Managed Bd Instl; 5. Putnam Diversified Income A
- 2 DISCLAIMER: MPI conducts performance-based analyses and, beyond any public information, does not claim to know or insinuate what the actual strategy, positions or holdings of the funds, portfolios or organizations discussed are, nor are we commenting on the quality or merits of the strategies. This analysis is purely returns-based and does not reflect insights into actual holdings. Deviations between our analysis and the actual holdings and/or management decisions made by funds and/or organizations are expected and inherent in any quantitative analysis. MPI makes no warranties or guarantees as to the accuracy of this statistical analysis, nor does it take any responsibility for investment decisions made by any parties based on this analysis.
- 3 Filtering for one per fund family, the five largest Non-Traditional Bond funds as of April 30, 2018, were: 1. BlackRock Strategic Income Opps Instl; 2. JPMorgan Strategic Income Opports R5; 3.Guggenheim Macro Opportunities Instl; 4.Eaton Vance Glbl Macr Absolute Return A; 5. Goldman Sachs Strategic Income Instl
- 4 The average fund in Morningstar’s Non-Traditional Bond category outperformed the Bloomberg Barclays U.S. Aggregate Bond Index by a cumulative (non-annualized) 8.35% in the two-year period from June 1, 2016, to June 1, 2018, while the average of the top five funds in the category outperformed the Index by 15.56%.