As such, allocation to these funds should be partly determined by an investor’s allocation to other asset classes, particularly equities. In adding unconstrained, the most important concept is that portfolios with these funds will tend to have higher correlations with equities and credit.
One of the counterintuitive implications is that unconstrained funds can actually be most useful in more conservative portfolios that are dominated by traditional bonds. This is because unconstrained funds’ equity and credit exposure may actually add some diversification, in addition to yield.
To be sure, unconstrained bond funds are no panacea. A portfolio containing an unconstrained bond fund will likely have modestly higher risk. This reflects the likelihood that the unconstrained portfolio will contain more credit and equity exposure, both of which add to the overall riskiness of a portfolio.
In addition, in a world of low yields and tight spreads, returns to these funds are also likely to be modest, at least relative to periods when yields were much higher. It’s also important to note that not all unconstrained funds are the same. Moreover, given their flexible natures, they will have different exposures over time, leading to different performances over different periods.
Still, in an environment characterized by low nominal yields, often negative real yields and elongated duration, unconstrained bond funds are an alternative solution worth considering.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.