What A Urinal Ad Can Teach Us About Unconstrained Bond Funds

 

Mens Bathroom

It has to be the best urinal ad- ever.

Right above the urinal a movie theater bathroom, in red letters “Flat rate divorce services”. The ad had a nice picture of an office and the attorney’s phone and email address.

Talk about a captive audience- really sort of brilliant. You’re a guy, you’re absolutely going to notice ad, lots of marriages end up divorce…..

Simple.

When it comes to investing, however, money management can become really complex- maybe even too complex for the portfolio manager’s own good. Individual investors are pitched mutual funds and ETFs that are far more complex than simply a stock or bond fund. Ask yourself: At some point, does the investment strategy become too complex to keep track of?

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That may be true of an unconstrained bond fund.

Addressing interest rate risk

Bonds are subject to interest rate risk, which is risk that interest rates will increase and force down bond prices. Think about it this way: You own a 10-year 5% IBM corporate bond, and interest rate go up. Now, IBM must issue bonds at current interest rates- say 6%. If new 10-year IBM corporate bonds are being issued at 6%, the 5% bond’s price will go down.

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The problem is that investors own billions of dollars in individual bonds, as well as bond mutual funds and ETFs. In recent years, we’ve been in a record-low interest rate environment and rates are going up (slowly). That situation means that all bonds- regardless of credit rating and maturity date- will decline in value to some extent.

A proposed solution

In recent years, money management firms have tried to address the bond fund/ interest rate problem by introducing the unconstrained bond fund. The premise is that, by investing in just about any type of bond, you can own a bond fund that can minimize interest rate risk.

The portfolio manager’s challenge is to manage a fund that invests in any type of bond (treasuries, agencies, municipal and corporate bonds) issued anywhere (U.S., Europe, Developing Markets, Emerging Markets) with any type of credit rating (AAA to B and lower) and any maturity (1- 30 years or longer).

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Well, I’m exhausted just thinking about managing this type of portfolio. You can see how many different factors must be taken into account. Here are just a few:

Average maturity: What’s the average maturity of all the bonds in the portfolio? How many bonds are callable? How are bond yields changing in all of these markets- which impacts whether or not a bond is called?

Credit ratings: Are any of the bonds at risk of a credit rating downgrade? Are the financials for an emerging market debt instrument reliable? After all, we rely on the balance sheet to determine the amount of leverage the issuer takes on. The income statement tells us if they can generate enough income to make the interest and principal payments. Does the issuer issue a reliable audit opinion- are accounting standards followed?

Size of market, liquidity: How big is the trading volume for each of these securities? If the portfolio manager needs to sell a bond, is there a large enough market to sell the holdings?

All of these factors impact a bond fund’s performance. With so many different bonds in one portfolio, managing the fund is even more complex.

Finally, the average expense ratio for an unconstrained bond fund is higher than a traditional bond fund. That makes sense, because the unconstrained fund is more complex- which leads to higher expenses.

Before your invest in an unconstrained bond fund, take a hard look at the costs and performance. As always, these posts are for informational purposes only. Consult a financial or tax advisor as needed.

Ken Boyd
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
Co-Founder: accountinged.com
(email) ken@stltest.net
(website and blog) http://www.accountingaccidentally.com/
(you tube channel) kenboydstl

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