NEW YORK -- Bond funds aren't boring anymore.
A new kind is on the scene, after many of the formerly steady and reliable workhorse investments lost money last year for the first time in more than a decade. Analysts say conditions will remain tough for bonds, but the industry says these funds can better withstand the challenges. They have more tools at their disposal than traditional bond funds. They can invest in more complex corners of the bond market and employ strategies to make money even when bond prices fall.
They're called unconstrained bond funds, and they've been a hit. Morningstar includes them in its nontraditional bond fund category, which attracted $55 billion in net investment last year. It's in stark contrast to the $79 billion that investors pulled out of Intermediate-term bond funds, the largest bond fund category. But investors should also take heed that unconstrained funds carry their own risks.
"These funds have lots of flexibility," says Eric Jacobson, a senior analyst at Morningstar, "but that flexibility can be just as dangerous as it can be advantageous."
As "unconstrained" funds, they don't measure their performance by the same benchmarks as others. Many traditional funds, for example, compare themselves against the Barclays U.S. Aggregate Bond index, which includes everything from Treasurys to securities backed by commercial mortgages. The index lost 2 percent last year.
The culprit: rising interest rates. When rates rise, the lower yields of existing bonds become less attractive. That drives down their prices. After three decades of declines, the yield on the 10-year Treasury note rose last year to 3 percent from 1.8 percent. Many strategists expect rates to keep rising, though in fits and starts.
Nontraditional bond funds, in contrast, posted an average return of 0.3 percent.
Many have bulked up on junk bonds, which helped to drive the performance. They're riskier because the issuers have relatively weak credit ratings, but they also offer higher yields to compensate. Managers of unconstrained funds also can invest in far-flung corners of the world, including emerging markets. Some also "short" bonds, which means that they profit when prices for the bonds fall.
The American Beacon Flexible Bond fund (AFXYX), for example, owns junk bonds, though it's more cautious than many peers and limits them to no more than 35 percent of its total assets. The fund also owns bonds from Mexico, Poland and elsewhere.
The fund aims to offer more stable performance by including bonds from around the world, says Gene Needles, president and chief executive officer of American Beacon. Its goal is to make money for its investors over a market cycle, which could be three to five years, says Jeffrey Ringdahl, American Beacon's chief operating officer.
Unconstrained bond fund managers also have more freedom to focus on investments that look good, even if they're only small parts of the index, says Meg McClellan, global head of fixed-income market strategy at J.P. Morgan Asset Management. Bond funds that must hew to a benchmark index, in contrast, are biased toward whichever governments and sectors are borrowing the most, because they make up more of the index.
"Benchmarks reward bad behavior: If you think about who's issuing the most bonds, it's the ones who are borrowing the most," McClellan says. "But if you're a lender, who do you want to lend to?"
Unconstrained managers can look for bonds where they expect to soon see credit-rating upgrades or bonds from countries where debt levels are low, regardless of how small a part they are of the index, she says.
J.P. Morgan Funds has several bond funds that can make such wide-ranging moves, including the Multi-Sector Income fund (JSISX), the Global Bond Opportunities fund (GBOSX) and the Strategic Income Opportunities fund (JSOSX).
To be sure, traditional bond funds have performed quite well over the last month. Interest rates have dropped amid worries about tumult across emerging markets. The yield on the 10-year Treasury is back to about 2.7 percent. That shows that investors still have a place for Treasurys and other traditional bond funds in their portfolios, says Morningstar's Jacobson. They have been good historically at providing stability to a 401(k) or other portfolio, dampening the swings that stocks and riskier bonds can take.
Among other risks that investors should heed when considering unconstrained funds:
-- Credit risk. The big worries about rising interest rates mean many unconstrained funds have limited their susceptibility to the risk of rising rates. But to make money, unconstrained bond funds need to take risk somewhere. Many have done that with junk bonds, which would be hurt if the economy weakens and more companies begin defaulting.
-- Short track records. Many unconstrained funds are only a few years old. "These funds have so much latitude to change their opinion so quickly," Jacobson says, "that it leaves you with some uncertainty about whether or not they can repeat the same success again, even if they've shown success before."
-- Higher expenses. Analyzing bonds from around the world takes a lot of effort, and that comes at a price. The average nontraditional bond fund has an expense ratio of 1.31 percent, which means $131 of every $10,000 invested goes to covering operating costs in a year. The average intermediate-term bond fund, in contrast, has an expense ratio of 0.89 percent.