The refrain has been consistent from market pundits—rates are too low and have no place to go but up. First it was the end of quantitative easing that would be the undoing of the bond market; then it was the inevitable Fed rate hikes that would usher in the dark times. It seems that every year since the global financial crisis of 2007–2008, the narrative has been one of “normalization” for U.S. rates.

Of course I’m not trying to suggest that bond investors should expect this type of return going forward. If anything, we should maintain lower expectations for market returns. The point I’m trying to make is that predicting the direction of interest rates has historically been a very difficult and often painful endeavor, which is now having consequences for some riskier bond investments.

An unconventional option

Some investors, in an attempt to counter a potentially rising rate environment, had turned to unconstrained, or alternative, bond fund strategies. Unconstrained bond funds are sold with the promise of delivering alpha above an index, often with the powerful lever of having the flexibility to adjust duration¹ in anticipation of a move in rates. But, with rates stagnant, unconstrained bond funds have underdelivered. And investors are voting with their feet.

This chart shows annual cash flows into three types of bond management strategies: active, passive, and nontraditional (or unconstrained). While nontraditional bonds seemed to finally attract cash flows around 2013, their cash flows have dropped and dipped into negative territory starting in 2015.

Annual cash flows

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Source: Morningstar, as of June 30, 2016.

Taking an informed approach

Former Ohio State head football coach Woody Hayes once said with regard to the forward pass, “Three things can happen when you throw the ball, and two of them are bad.” The same is true for being short the bond market in anticipation of higher interest rates. Rates could rise (good), rates could fall (bad), or rates could stay the same (bad). The first two outcomes are fairly obvious. To understand the third, it’s important to note that it’s not free to position for higher rates. All else equal, a fund taking a short-duration position relative to a market benchmark will typically have lower carry (return from income).

There may always be unconstrained funds that are able to add value, but the trick is finding the ones that can consistently add value after they overcome an annual headwind of higher costs relative to an index fund. My colleague Josh Hirt did his homework on this last year, and I recommend a thorough read of his research for anyone considering nontraditional bond strategies.

As hard as it is to predict the direction of interest rates, index funds aim to deliver the return of the market, minus expenses and tracking error, and they are going to do so in a low-cost, diversified way. So unless your crystal ball is clearer than most, getting bond market exposure in an index fund is as compelling as ever.

¹Duration measures the sensitivity of a fixed income investment to changes in interest rates.

Notes:

  • All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
  • Investments in bonds are subject to interest rate, credit, and inflation risk.