The biggest mistake investors are making right now

Or perhaps we should say that we are now firmly in the pre-crisis period given that, statistically speaking, the next calamity is probably right around the corner.

It’s been so long since the last major market event that investors have returned to one of their time-honored traditions—denying the link between higher risk and higher reward. The worst part is that they are doing this in the fixed income side of portfolios, taking equity-like risk with their bond funds, guaranteeing that the protection from volatility that bonds offer does not show up when it is most needed.

This sort of makes sense when you consider that just a few years ago they were flocking to the “bond-like stocks” pitch. Thanks to the looming possibility that interest rates will rise in the coming months, today’s obsession with owning bond funds that do not act like bond funds is simply the latest episode in a long string of mass delusions.

Before we go any further, let’s remember why people with a multi-decade time horizon in front of them use bonds in a portfolio to begin with. The simple fact is that most fixed income is not correlated to the stock market. Investment-grade corporate bonds and sovereign debt instruments like Treasurys tend to zig when the equity market zags, allowing investors to hedge against the volatility of stocks and preserve the opportunity to rebalance their portfolios.

This is a core tenet of retirement investing and, best of all, it’s something that we know works. In fact, since 1976, U.S. stocks and bonds have not declined at the same time for more than two consecutive months. Over the last 60 years, there’s only been one year in which both stocks and bonds posted an annual decline (1969). Historically, owning a portfolio of both stocks and bonds while rebalancing opportunistically or mechanically works extremely well for a retirement portfolio over all reasonable time frames.

But of course, we tend to be willing to ignore historical facts when a more convenient promise comes along. And in this care, that promise is the rise of the unconstrained bond fund.

With interest rates at zero and improving economic data cropping up everywhere, people have begun to grow paranoid about the duration risk of their plain vanilla bond funds. Duration is the change in value expected in a portfolio due to a 1% change in interest rates. The longer a bond fund’s duration, the greater the threat from rising interest rates.

But fear not! The salesmen on Wall Street have something new and exciting to sell you. What if we could put you in a bond fund with the features you want—high current income, for example—but without the stuff you’d rather avoid, like duration risk? You’d like that, wouldn’t you?

Allow us to introduce you to the Wonderful World of Unconstrained Bond Funds.

The popularity of this type of fixed income fund has exploded, and it is entirely a creature of the zero interest rate percentage environment. Between the beginning of 2010 and the end of 2014, the assets under management in the top 10 “nontraditional bond funds” have quintupled from $16 billion to over $80 billion. In fact, these 10 funds have seen their assets double over just the last two years. Investors are willing to believe that they can put their money into fixed income and not have any of the downside that comes with rising rates.

Having analyzed the holdings of these funds, their performance in varying market conditions, as well as having spoken to several advisors and investors who are using them, I’ve arrived at the conclusion that this could be a big mistake we will all lament. Let me be clear that the problem isn’t with the funds themselves; they seem to be delivering exactly what they are attempting to, for the most part. Instead, the issue is with how these funds are being used in investors’ portfolios, and how they are being sold to people.

If the benefit of including bonds in an investor’s portfolio comes from the fact that they are uncorrelated—or even inversely correlated—with stocks, then swapping out a fixed income allocation with a nontraditional bond fund won’t get the job done. These funds do not act like bonds in volatile markets and, in some cases, they act exactly like equities. Hence, the diversification benefit of investing in bonds goes away and the risk for investor portfolios is amplified.

The evidence is clear. The top 10 non-traditional bond funds are simply substituting one risk for another. In an effort to reduce the aforementioned duration risk, these funds are taking on risks of a different sort. One of the iron laws of finance is that reward does not come without risk and fixed income products are bound by this law just like any other products would be.

Looking at the top 10 non-traditional bond funds and their current portfolios, we see that these funds are doing several things that bring on risks of a different sort than what you’d expect from a plain vanilla bond fund. Here are a few examples:

1. Leverage: According to Bloomberg, the $2.45 billion Mainstay Unconstrained Bond Fund is currently holding 198.4% of its assets in corporate bonds. The $28 billion Blackrock Strategic Income Opportunities Fund, the largest of the group, is currently 202% long the mortgage bond market. By adding leverage, a low duration portfolio is de facto magnified to a very large degree.

2. Market-timing risk: JPMorgan’s $22 billion Strategic Income Opportunities Fund, the second largest of those I examined, is currently reporting that its top asset class is cash, accounting for 45% of the fund’s assets under management, or roughly $10 billion. Note that this is actually down from a reported 65% last fall, although interest rates have not exactly risen since then. Putnam’s Absolute Return 300 Fund and the Driehaus Active Income Fund are holding 14% and 21% of their assets in cash, respectively. The managers are doing what they say they’ll do, but are investors prepared for this level of tracking error should the bond market rally?

3. High costs: In the case of the JPMorgan fund, the manager is clearly attempting to time the market and hold out for better yields. Perhaps he will be able to pull this off, but at what cost? Investors in the “select” share class of this fund are paying 0.87% of their assets in the hopes that he can. Investors who bought A Class shares at a bank branch or from their broker are actually paying more than 1% and have also paid a 3.75% sales load on top of it.

4. Credit and geopolitical risk: With U.S. 10-year Treasury bonds currently offering yields of around 2%, you’re not going to be able to pull a 5% yield out of thin air. The top 10 non-traditional bond funds have instead been using their passports, which are stamped “go anywhere” according to their marketing materials. And so we see large allocations to bonds from Russia (John Hancock’s Short Duration Credit Opportunities Fund), bonds from Luxembourg and Indonesia (Columbia Strategic Income), a large position in Brazilian bonds (PIMCO Unconstrained), and even holdings in practically bankrupt countries like Argentina and Greece (Putnam Diversified Income Trust). All of these international credits could potentially be winners, but there is nothing about them that will satisfy the risk characteristics that many investors expect from their bond holdings.

5. Increased volatility: If you’ve replaced your traditional fixed income investment with an unconstrained bond fund, the bad news is that your fund may act entirely unbond-like at the worst possible time.

From September 19 through October 16 last fall, the S&P 500 had a correction of 7.19% (on a closing basis) while the Vix (volatility index) spiked by 150%, the biggest jump since the May 2010 Flash Crash. This was an excellent proving ground for a diversified portfolio, and bonds did not disappoint. During this plunge, traditional bond indices earned their keep, with the 7-10 year treasury bond index gaining 3.36% during the period while the 20+ year Treasury index rose 6.24%.

Meanwhile, an equal-weighted basket of the top 10 non-traditional or unconstrained bond funds actually posted a drop of 1.83%—not exactly what one would expect from a fixed income investment during a stock market swoon and a bond market rally. The Barclays U.S. Aggregate Bond index ETF, AGG, was actually up 1.84% during the same period. It should be noted that this index can be owned for a whopping 8 basis points in cost and it yields roughly 2.25%.

The question that needs to be asked is, “what happens to these non-traditional bond funds should the next stock market correction be worse than a mere 7%?” The answer? It’s unclear, but we know for sure how they handled the last spate of fear and it wasn’t pretty. One of these funds, according to my analysis, saw its net asset value (NAV) drop by a whopping 5%.

By buying heavily into the premise that they can earn bond-like income without the risk of rising rates, investors may have merely swapped one risk factor for another. They may have also distorted the expected diversification benefit they’d traditionally get from fixed income at exactly the worst time, given how long the current bull market for U.S. stocks has been running.

This attempt at investing alchemy may be the biggest mistake you’re making right now. My advice: review your fixed income investments and make sure you understand exactly the risks you are taking.

Editor’s note: A previous version of this story reported that the $1.17 billion Western Asset Management Total Return Unconstrained Bond Fund had a mix of 378% corporate bonds, 236% mortgage bonds, and 232% government bonds. These figures were based on data provided by Bloomberg and suggested that this fund was highly leveraged. After the publication of this piece, Western Asset Management and Legg Mason, its parent company, appealed to Bloomberg to alter the method used to calculate this fund’s asset mix, based on what Western Asset Management asserts are industry standards. After that recalculation, the asset mix of that particular fund, as reported by Bloomberg, is 35.57% corporate bonds, 33.22% government bonds and 31.48% mortgage bonds.