Over the past several years, so-called unconstrained funds have fallen in and out of favor with investors; arguably for good reasons. Despite their classification as unconstrained, most such funds actually do operate within self-imposed constraints. Therein lays the challenge for investors. Industry defined parameters around unconstrained funds don’t exist. Each manager can design his or her strategy however they choose. The result has been significant dispersion of returns across managers and, in some years (2014 and 2015, in particular), average performance that lagged traditional fixed income as represented by the Bloomberg/Barclays US Aggregate Index (“Aggregate”). It was not uncommon for a top performing manager in one year to become a bottom performer in the next. See the below chart for the range of returns in the Morningstar category for non-traditional fixed income funds.
Investors buy fixed income as a lower volatility component in their overall portfolio that, by design, should lower rather than increase the dispersion of overall returns. The fallout from unexpected volatility in the performance of unconstrained funds has resulted in a steady outflow of money from them.
Now that the Federal Reserve has begun raising overnight rates in the US, it may be an excellent time to revisit these unconstrained strategies. Traditional fixed income strategies such as those managed relative to the Aggregate index, for example, generally do not perform well as rates rise. With roughly five years of duration and 2.65% yield, a 50 basis point increase in rates would offset a year’s worth of yield. Could this happen? 10-year Treasury yields rose by 56 basis points in the month of November 2016 alone. In the five periods of rising rates since December 2010, four have exceeded 50 basis points. See below chart. With the Fed poised to raise rates three more times in 2017, the probability of a similar rise along the yield curve is increasing.
When rates rise, bond prices fall. However, that does not mean that all fixed income investments will lose money. We believe that well diversified strategies with the flexibility to invest in all of the sectors available in the global fixed income market and that actively manage duration can provide attractive returns regardless of the interest rate environment.
Conclusion: Choose Wisely
The impetus to invest in unconstrained strategies post crisis was clear. Rates could only move higher following years of unprecedented accommodative policy; a fixed income flexible approach with less rate sensitivity seemed a failsafe solution. The case for these strategies has certainly been muddied by inconsistent performance across some of the largest funds in the universe, in addition to resilient performance from traditional bond investments as global growth has remained sluggish and duration has outperformed. The general flexible approach however, should not be cast aside. Unconstrained managers can be effective complements to traditional fixed income allocations, improving risk-adjusted returns over time, as our analysis shows.
Return dispersion in the universe, however, offers clear evidence of heterogeneity across the very broadly defined unconstrained category. While flexible managers certainly should not be dismissed, their individual approaches should be carefully scrutinized and understood in the context of the investor’s broader fixed income allocation and risk tolerance. In short, with an unconstrained allocation, one is substituting traditional benchmark risk for manager risk. We still advocate strongly for the benefits of an unconstrained strategy and believe analyzing a few key factors, highlighted below, can help investors better evaluate these managers.
 Yield and duration estimates as of January 31, 2017.
French government bonds sold off to yield about 85 bps more than equivalent 10 year German government bonds as political uncertainties hit a peak last week. Given that the Presidential election is not due until 23rd April (with a likely second round due to take place on 7th May), opinion poll jitters are likely to continue to drive market flows over the next couple of months.
To an extent, it is perfectly rational for the market, after having been surprised by the Brexit and Trump votes last year, to try not to be caught out by a surprise Le Pen win in France later this year. Should she be elected President of France, amongst her agenda items, Marine Le Pen wants to take France out of the Eurozone and the EU. The market has therefore been worried about French debt redenomination from Euros into potentially weaker French Francs. As long term investors, we have to respect market themes (which have recently been to sell French risk as Le Pen rises in the polls), but we also have to remain grounded on the still low probabilities of such wing scenarios actually occurring, plus the longer term positives such as the entrenchment of the economic recovery across Europe. Our investment decisions therefore have to weigh up the short term risks of fear of political turbulence against the longer term odds that still favour the status quo (France staying in the Eurozone and in the EU). How do we get from here to there?
We recognise that each time Le Pen gains in the opinion polls, French government bonds are likely to underperform. Le Pen has consistently led in the polls when it comes to voting intentions in the first round of the elections. On that basis, she is likely to reach the second and final round a fortnight later to face a centrist candidate, currently likely to be one of Emmanuel Macron or Francois Fillon. Neither of these centrist candidates has yet to establish a solid support base and it is this, plus the controversies that surround Fillon’s previous use of public funds, that have fed fears that the Le Pen may actually win. Fillon recently made a statement that he would not step out of the race and has continued to deny any wrongdoing.
Nevertheless, we have to recognise that notwithstanding a potential first round win, Le Pen continues to trail either of the centrist candidates by a substantial margin in second round opinion polls. Whilst this gap has recently closed, it is still a tough hurdle for Le Pen to overcome. Secondly, we have to recognise that in addition to winning the Presidential election, Le Pen’s National Front also has to win the parliamentary election in mid-June, where 577 seats are up for grabs and Le Pen’s party currently has only two. In the event that the Socialists and Republicans hold on to a majority of seats (and neither would go into a coalition with the National Front), it is more likely that “cohabitation” occurs, with the President driving foreign policy and Parliament driving domestic policy. Parliament of such a make-up is unlikely to vote for a referendum on whether France should leave the EU/Eurozone. Finally, as if the prior hurdles are not tough enough, support for the euro amongst the French electorate remains extremely high.
In spite of all the above, if the consensus is to panic over France, the consensus will continue to panic over France! French spreads have widened since the start of this year and the elections are still two months away. Two months is a long time to be overweight French risk if the market wants to take French spreads wider. Hence the value of our “Fundamental, Quantitative and Technical” approach to investing. Market technicals have been poor and have driven French spreads wider – we have respected that by not (yet) fading French spread widening. Yet Fundamentals and Valuations are improving. The Eurozone recovery is now well established and looks sustainable. France’s Q4 GDP grew by 0.4%, QoQ, not annualised, a strong outcome. In addition, the PMI composite index hit a multi- year high of 56.3 in February, again supporting the notion that the recovery is likely to continue, making France attractive once political uncertainty is out of the way. The ECB meanwhile will continue to mop up €60bn of Eurozone bonds every month until December.
We have been close to neutral on French government bond risk since early this year and have kept our powder dry, recognising that volatility in the polls will lead to spread widening or spread contraction. We plan to look to re-build French exposures when we believe that consensus is about to turn back towards viewing France in a more favourable light. Meanwhile, we watch and we wait, but we are ready when our overall F, Q, & T signal tells us to re-engage.
J.P. Morgan Asset Management does not predict outcomes of any political events, nor do we voice firm-wide opinions on any political candidates.