Investors Warming to Unconstrained Fixed Income

Major changes are occurring in the fixed-income markets that are driving asset managers to position clients against volatility and future rate tightening, according to Cerulli Associates.
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The November 2014 issue of “The Cerulli Edge – U.S. Monthly Product Trends” examines ongoing fixed-income investing developments and finds institutional investors, including employer-sponsored retirement plans, are increasingly considering unconstrained and absolute return fixed-income strategies. As Cerulli explains, unconstrained strategies allow a manager to construct a portfolio that bears little or no resemblance in duration, credit, or currency exposure to a benchmark.

Recent Cerulli surveys confirm managers are rapidly organizing unconstrained and multi-sector products, the report says. As of September 30, global unconstrained fixed-income strategies held $164.5 billion in assets, according to eVestment stats cited by Cerulli. Net flows totaled $9.2 billion year to date, which is down from a robust $43.6 billion observed last year. Growth in unconstrained strategies comes off of a relatively low base, the report explains, meaning substantial inflow volatility can be expected.

“It takes time to frame an absolute-return-type strategy to investors who are used to evaluating performance of a core/core-plus strategy against a benchmark,” Cerulli says. Researchers point to the University of Notre Dame as an example. The university considers unconstrained fixed income to be among “marketable alternatives,” including multi-strategy, hedge funds, structured products, direct lending, high yield and distressed debt.

Cerulli points to bond market volatility as a leading factor underlying greater unconstrained fixed-income usage. The analysis shows that the yield on 10-year Treasury notes experienced an intraday drop of as much as 30 basis points on October 15, “a move almost unheard of in bond market trading, and the most since 2009.”

As Cerulli observes, that same day brought a record volume of $945.9 billion in trades in the U.S. Treasury market, according to the Association for Financial Professionals. At the same time, credit, equity, and other risk assets were riding a “four-week roller coaster featuring 100-point daily swings in the Dow Jones Industrial Average.”

Also diminishing reliance on traditional bond strategies is the fact that bond markets have defied the expectations of many investors so far in 2014. Many predicted 2014 would be the year rates started to rise from prolonged and historic lows, but Cerulli says the 10-year Treasury note, which started 2014 at a yield of 3.03%, instead steadily declined for much of the year—only to go back up to more than 2.6% in September. Then it rapidly reversed again, Cerulli explains, and the yield fell to a yearly low of 2.05% on October 16. The 10-year Treasury note finished October at 2.34%.

“These changes are attributed to the markets’ coming to grips with the end of the Federal Reserve Board’s quantitative easing policy and an eventual increase in interest rates,” Cerulli says. “Quantitative easing’s support of government bond markets (and, therefore, the suppression of longer-term rates) was unprecedented as the Fed’s balance sheet ballooned to $4.5 trillion at the end of October, from $883.4 billion in 2007.”

Cerulli says fixed-income markets are also still sorting out the implications of the abrupt departure of PIMCO’s Bill Gross to Janus Capital Group on September 26. The PIMCO Total Return Fund lost about $23 billion in a matter of days during September, Cerulli says, and October revealed an even larger monthly net withdrawal, exceeding $27 billion, totaling 18 consecutive months of outflows for the embattled fund.

Most of the early redemptions from PIMCO funds were attributed to retail investors (see "Too Early to Hit the PIMCO Panic Button"). However, Cerulli says senior executives from publicly traded asset managers such as BlackRock and Legg Mason have stated on earnings calls that tens of billions of dollars in institutional money is in motion as a result of Gross's departure from PIMCO, with a good portion destined for unconstrained bond and absolute return strategies.

That said, Cerulli believes the changes occurring in the fixed-income markets “speak more to asset managers’ efforts to position clients against volatility and future rate tightening than it does about the story of a star manager.” Although many institutions and their investment consultants have put PIMCO on watch lists for now, only a few public or corporate funds have so far moved to terminate the manager, Cerulli adds.

The report concludes that retirement plan service providers, from asset managers to advisers, should use this changing environment to better position their fixed-income offerings. “Managers should look critically at their platforms if they are overly skewed to core bond, or consider whether they offer the global credit research or derivatives capabilities that often come with unconstrained mandates,” Cerulli adds.

In general, those service providers that are proactive in helping clients through these changing times will likely be successful in retaining fixed-income clients in the long run, Cerulli says.

Information on how to obtain Cerulli Associates reports is available here.