These bond funds could take off as Fed policy becomes uncertain

With Wall Street uncertain as to where the Federal Reserve will go from here on rate policy, an actively managed approach to fixed income could see additional interest – and inflows – from investors. The central bank stood pat on interest rates at the conclusion of its meeting last week, noting a “lack of further progress” on inflation. This finding threw economists for a loop, with investment banks Barclays and Bank of America forecasting just one rate cut, while Citigroup called for as many as four. That shakiness around when the cuts are coming, as well as the expectation that rates could remain higher for longer creates an opportunity for active managers. “When you have inflation running higher and a yield curve that is flat to inverted, why would you want to own the index?” Rick Rieder, BlackRock’s global chief investment officer of fixed income, told CNBC in a phone interview. “A huge chunk of the [Bloomberg Aggregate Bond] index is long duration. Why would you want to own it?” Duration is a measurement of a bond’s price sensitivity to fluctuations in rates. Bonds with long-dated maturities tend to have greater duration. Bond yields and prices have an inverted relationship, so in a time when interest rates are high, the long-dated issues could see sharp swings in prices. Active fund managers in the fixed income space have the flexibility to tailor their exposure in an array of income-generating assets and along the yield curve. “Today, having more tools at your disposal means you can eliminate the parts of the index that aren’t worth owning,” said Rieder, who is also portfolio manager o f BlackRock’s Strategic Income Opportunities Fund (BSIIX) and Flexible Income ETF (BINC ). Portfolio management flexibility BSIIX, which has a 30-day SEC yield of 5.25% and a net expense ratio of 0.74%, is an unconstrained bond fund – or a member of the nontraditional bond category, per Morningstar. Unconstrained portfolios allow managers the flexibility to invest in an array of income-generating asset classes, including foreign debt, and to handle interest rate sensitivity to keep a lid on volatility. The category held up during 2022 – the year that the Federal Reserve began its round of rate hikes – with the average nontraditional bond fund sliding 6.1% that year, while the average intermediate-term core plus bond fund fell 13.4%, according to Eric Jacobson, director of manager research, U.S. fixed income strategies at Morningstar. Where unconstrained strategies can run into trouble is in a credit crisis. “2008 is an example of this, when we have that kind of instability and everyone is afraid about credit risk and the only thing that performs well is Treasury bonds,” he said. Another active approach that could see further traction as the rate climate becomes uncertain would be the core and core-plus categories. Though both include corporate, government issues and securitized debt, the latter gives managers the flexibility to snap up high yield bonds, bank loans and emerging markets debt, according to Morningstar. “We think that if you’re venturing beyond the comfort and confines of cash, a great place to start is in a core or core-plus active strategy that is still going to be tethered to a high quality U.S. investment grade universe,” said John Croke, head of active fixed income product management at Vanguard. “This message of ‘let the professionals allocate risk and find those opportunities’ is something that we’re seeing some traction with,” he added. Indeed, core bond funds were among the winners in the 2008 crisis. They also held their own during the Covid-19 downturn, benefiting from a combination of intermediate duration – roughly six years for some – and diversification across Treasurys, mortgage-backed securities and corporate bonds. Picking the right offering Investors should prepare to do some homework as they dig through these different options. For starters, they should think about the role they want a given bond fund to play within their portfolio: Is it to offset equity risk or to boost returns? “You’re not investing in bond funds to shoot the lights out and build your wealth pile,” said Morningstar’s Jacobson. “They are there for ballast, balance and insurance – that’s the way I like to think of it.” If your search takes you toward an actively managed strategy, read into the manager’s approach and learn about their methodology for investing. The prospectus is a good place to begin. “You would want to look at the mandate and look into the strategy,” said Jaime Quinones, a certified financial planner at Stockade Wealth Management in Marlboro, N.J. “See what the guideposts are and that could be a starting point to compare one flexible approach to another.” Finally, investors should aim to be fee conscious and tax aware. Actively managed funds generally cost more than their passive counterparts, and those that have a lot of turnover can also come with a bevy of tax impacts from capital gains and losses generated within the portfolio. As a result, these funds would be better held in your tax-deferred accounts, such as an individual retirement account. “Mutual funds are great for active management, but they’re not the most tax efficient or the lowest cost,” Quinones said.