Unconstrained bond investing – an introduction

Unconstrained bond investing strategies can provide a solution for today’s investors and tomorrow’s returns. Here we outline what unconstrained investing strategies are, and why investors should consider them now.

Why unconstrained investing? Why now?

Investors are seeking alternative de-risking options

For the past 30 years investors have enjoyed outsized gains from both equities and bonds. However, since 2008, risks have mounted; today’s end-of-cycle market backdrop is a challenging environment for any investor seeking to retain value in their portfolio while generating additional meaningful returns. As such, investors are asking themselves 'What can I do to further reduce risk and protect myself in this environment?'

Unconstrained bond investing strategies have, as a result, become increasingly popular. Thanks to their unlimited and dynamic nature, these strategies offer investors full-spectrum access to the bond market while diversifying against credit and interest rate risks as well as drawdowns.

'Typical' unconstrained bond strategies

Return expectations

One of the most common expectations from investors is that the unconstrained bond investing approach is a ‘go-anywhere strategy’, i.e. risk will be increased when the market outlook is attractive, and risk will be decreased when the outlook is unattractive. The lack of benchmark requirements means that typical strategies have a very open spectrum of investible assets.

This is of course an opportunity. But, in our view, the full benefit of unconstrained bond investing is that it can be much more tailored and customized versus traditional investing approaches. Truly flexible unconstrained bond strategies should seek to find assets which have high risk-adjusted returns and a high degree of certainty around delivering on these potential returns. Success isn’t just about selecting assets with the best returns, the key is delivering on these returns.

Exposure to credit risk and interest rate risk markets

Many unconstrained bond market players have relatively high levels of interest rate risk or credit risk within their strategies. This is because they tend to rotate primarily through those particular risk-sensitive assets. Whilst credit risk and interest rate risk are the two most common concerns for fixed income investors, overreliance or focus on these two risks means that – at any one time, the strategy will be exposed to one or the other risk.

Decoupling is key

Overall, the separation from a benchmark provides unconstrained bond strategies the flexibility, if harnessed correctly, to add diversification and provide absolute returns with greater certainty. We have a slightly different view on the opportunity presented within unconstrained investing, versus the traditional approach. Decoupling1 from the benchmark is important, but we think that strategies should also decouple from those traditional credit and interest rate risk markets, and should seek out alternative diversification opportunities.

Unconstrained bond investing: Market backdrop and 2019 outlook

2019 is another action-packed year and our overall macro view is that we will face a difficult economic environment going forward. For fixed income investors (and unconstrained bond investors in particular), there are three key themes to watch for over the rest of 2019: the late-stage economic cycle, bond supply and credit spreads.

  1. Economic cycle
    The maturing economic cycle combined with market growth and rising interest rates means that major central bank support is less necessary. While we have seen the U.S. Federal Reserve slow down their rhetoric around interest rate hikes and tightening monetary policy, the economic backdrop still remains strong in the U.S., with full employment and strong consumer activity. Investors could easily shift their focus back to inflationary pressures and the consequent impact on interest rates as the year progresses.

  2. Bond supply
    Supply of government bonds is likely to increase given that large deficits are financed through the bond market. The U.S. tax cuts in 2018 have dramatically increased the deficit with 4.5%-5% expected for the next 10 years on the current trajectory. The bond market will need to absorb this extra supply in order to finance this spending, which will put pressure on bond yields.

  3. Credit spreads
    Credit spreads2 have been tight for some time now, which hasn’t left much room for disappointment. The recent performance of credit in the fourth quarter of 2018 has given a taste of what could happen, should economic growth disappoint. It is hard to justify the current lever of tight spreads with the low level of interest rates. One or the other needs to give, or perhaps both.

  4. What are the advantages of an unconstrained fixed income strategy in 2019?

    Against the 2019 economic backdrop, an unconstrained fixed income strategy offers investors the flexibility to ensure that assets are efficient and protected – both in terms of the risk exposures generally, as well as the risk of material drawdowns. Successfully implemented, an unconstrained investing framework over 2019 should generate material return above the risk-free rate3 whilst having built-in drawdown protection. The strategies are not riskless, and not a cash proxy, but offer attractive yield potential with meaningful real diversification.

    Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.

1Decoupling occurs when two different asset classes that typically rise and fall together move in divergent directions.

2The difference in yield between two bonds that have the same maturity but different credit quality, such as a 10-year Government of Canada bond and a 10-year corporate bond.

3The risk-free rate generally refers to the interest rate on short-term government treasury bills.