INSIGHTS

On April 14, 2014

Viewpoints from AAM - Unconstrained Fixed Income Investing and the U.S. Fixed Income Markets

Unconstrained fixed income investing has been in practice for years and has recently been in the headlines given the continued low interest rate environment. The concern in the traditional fixed income markets has been the net low yields not meeting investors’ expectations or requirements coupled with the associated principal risk with potential higher interest rates. Most would agree that the former is accurate and the latter is a real concern.

Enter unconstrained fixed income investing. Some money managers have practiced this type of investing for the past few years with the goal to add value to fixed income portfolios, for others this is a new topic. Although there are different descriptions for what unconstrained fixed income investments are, from my view, they are any income producing asset classes that are not traditional fixed rate U.S. bonds.

These alternative classes can be international bond funds and emerging market funds. They can also be nontraditional bond funds that are not tied to benchmarks. These funds can invest in illiquid securities, foreign debt vehicles or use various derivative investments. Unconstrained investing can also concentrate on total return instead of straight income. By definition this investing could include short selling, futures, options, leverage and unconventional assets. There is nothing inherently wrong with this type investing, however in my opinion it represents the extreme of unconstrained investing. Extreme as compared against a traditional bond that has a coupon, maturity, permanence and definition.

A more conservative, transparent and recognizable variation of unconstrained investing is non-bond-like income producing asset classes such as Real Estate Investment Trusts (REITs), Business Development Companies (BDCs), preferred stock, Master Limited Partnerships (MLPs), etc. These asset classes can be invested in individually or via various fund type vehicles such as Unit Investment Trusts (UITs), Closed End/ Open End Funds, etc.

When utilizing these type investment vehicles to enhance a traditional fixed income management strategy, it may prove beneficial to take an in-depth look at UITs. UITs deliver these various asset classes in a vehicle that is transparent and permanent, you know what you own, and they are priced daily with liquidity.

The flip side, in my opinion, is it would not be wise to abandon traditional fixed income instruments. Fixed income bonds can provide a clean, pure way to derive fixed income with a defined maturity date. Bonds are typically higher in the credit security pecking order and barring default, bonds typically deliver the expected results – a stated income with a defined maturity date. Arguably the more complex, illiquid and nontraditional an income producing investment is, the higher the risk.

It would be comforting and wise to keep an appropriate percentage of one’s investment portfolio in traditional fixed income investments, in my view. You know what you own, the amount of income that is received, and when your principal is returned. There is a lot to be said for this during times when the investment environment is volatile.

When investing in traditional fixed income bonds, and given the current market environment, an investor can receive a relatively higher return by extending maturity even a short period of time to take advantage of the yield curve. Please note any extension of maturity typically leads to higher market risks. 

This pursuit of value in the bond markets can be explored further by reading Viewpoints from AAM - Finding More Yield in a Low Yield Bond Market Environment an AAM blog written on February 10, 2014. This strategy is as applicable now as when written. I don’t feel fixed income investing should be abandoned as it can be a vital investment strategy and many investors still need income; just take advantage of what the market in the traditional fixed income asset classes can offer the investor. Invest in alternative fixed income asset classes; absolutely! Just remember fixed income investing does have risks, including credit risk and interest rate risk, so please make sure the investments are within the risk tolerance of the investor.

An investment in bonds is subject to numerous risks including higher interest rates, economic recession, deterioration of the bond market, possible downgrade changes to the tax status of the bonds and defaults of interest and/or principal. Certain bond issues may be redeemed in whole or in part before their stated maturity under certain circumstances. If this happens, the trust will distribute the principal to you but future interest distributions will fall. A bond’s call price could be less than the price the trust paid for the bond. If enough bonds are called, the trust could terminate earlier than expected. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Long-term bonds are generally more sensitive to interest rate changes. Additionally, the financial condition of the issuer may worsen or its credit ratings may drop.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com