The Risky Allure of 'Go-Anywhere' Bond Funds

This is the fifth in a series of five articles looking at the most popular bond alternatives and the safest ways to use them to improve your income prospects when rates are low. Adapted from “Reaching for Yield” in the January/February issue of Money magazine.

At a time when traditional routes to investment income aren’t paying off, it’s only natural to seek out pros who are willing to go off the beaten path. Enter “unconstrained” bond funds.

The appeal of these actively managed portfolios is that they’re not bound to invest only in the low-yielding government and corporate debt. Instead, they buy anything—foreign debt, asset-backed securities, stocks, preferreds, and even derivatives—to boost yields and hedge against price drops if interest rates rise.

Sounds good in theory. Alas, there’s no proof that derivatives and other exotica lead to better results. Pimco Unconstrained Bond, one of the biggest funds in the group, is up 2.8% annually over the past three years—that’s less than the plain-vanilla Vanguard Total Bond Market Index Fund. Plus, unconstrained bond funds are expensive, with average fees of 1.3% of assets, vs. 1% for the average bond fund and 0.28% for bond index funds.

Your best strategy: Let your managers roam—just don’t let them run completely wild. Before unconstrained bond funds came along, investors who wanted to give their managers a longer leash turned to multisector bond funds. These fixed-income portfolios also allow managers to invest in a wide variety of assets, such as junk and foreign debt, in addition to high-quality bonds. However, these funds typically set boundaries over what those areas are—and how much of the fund can wander there. This reduces risk, which should help to limit losses in bad markets. The approach also results in lower costs; the typical multisector bond fund has annual fees of 0.8% of assets.

T. Rowe Price Spectrum Income ­, for instance, can stray into emerging-market bonds and floating-rate bank loans, but only up to 10% of assets for each. This has been enough freedom for Spectrum Income to beat the Barclays Aggregate U.S. Bond index over the past three, five, 10, and 15 years. The same goes for Loomis Sayles Bond , a Money 50 fund that has also ­beaten at least 80% of its peers over the past three, five, 10, and 15 years.

Recognize, though, that while boosting your investment in multisector bond funds and other alternative assets can help boost your yield, the strategy isn’t a cure-all. Shifting 20% of a portfolio split fifty-fifty between stocks and traditional bonds into a mix of higher-paying alternatives might raise your yield from about 2% to 2.6% with little additional risk, says Geoff Considine, who runs the portfolio modeling firm Quantex. If you’re retired, that means you’ll still probably have to rely on principal and capital gains to fund at least some of your living expenses.

You might prefer to just cash dividend checks to pay the bills and leave the rest of your savings intact—but in reality, where you pull the money from isn’t that important, says Chris Philips, a senior investment analyst at Vanguard. Says Philips: “What really matters is maximizing the total return of your whole portfolio.”

More in this series:
The Smart Way to Invest in Dividend Stocks
High-Yield Bonds: Where to Look for Quality Junk
How Real Estate Can Boost Your Income in Retirement
How to Boost Returns When Interest Rates Totally Stink