As investors look for yield and interest rate protection, unconstrained fixed income is a category that has seen strong inflows in particular from institutional investors.
Unconstrained fixed income sits between traditional benchmark funds and fixed income hedge funds.
There is a clear distinction between unconstrained fixed income and traditional benchmarked bond funds: the former can dynamically invest in the full credit spectrum and derivatives without being limited to a benchmark.
Although the majority of unconstrained fixed income pooled assets are retail, recently this balance has seemed to be shifting towards institutional investors
However, the more complex unconstrained fixed income, such as absolute return funds, can be quite similar to hedge funds.
As my colleague Maxim Waller, the leader of our research in this area, puts it: “The main difference we find is that absolute return funds are cheaper, more transparent and less complex than hedge funds.”
Categorising unconstrained fixed income
We have broken down the space into three categories: traditional multi-asset credit, a second category that we call 'alternative multi-asset credit', and absolute return credit.
Traditional multi-asset credit uses a market or peer benchmark, and alternative multi-asset credit uses a cash benchmark or no benchmark.
While multi-asset credit focuses on credit spread opportunities and derives value from sector rotation, absolute return credit uses shorting and derivatives in the credit market to generate returns regardless of market conditions.
Spence Johnson’s Institutional Money in Motion project has revealed that unconstrained fixed income assets have seen growth of more than 55 per cent between the end of 2011 and the second quarter of 2015. This reflects a compound annual growth rate of 13.6 per cent.
At the time of the crisis, unconstrained fixed income pooled fund assets in Europe amounted to €20bn (£16bn). Now there is €171bn in unconstrained fixed income pooled assets across our sample of 165 unconstrained fixed income funds.
When you then add in our estimated €111bn in current unconstrained fixed income segregated mandates in Europe, the current total market in Europe is €282bn.
Recently, the growth in unconstrained fixed income has been driven by alternative multi-asset credit.
These funds have seen very strong growth, both in terms of assets and flow. Alternative multi-asset credit grew by 54 per cent from €35bn to €54bn between the third quarters of 2013 and 2015.
Traditional multi-asset credit and absolute return credit have, on the other hand, remained almost flat during the past two years.
Balance shifts towards institutional investors
It appears that flows during 2015 have been coming from institutional investors. This indicates that although the majority of unconstrained fixed income pooled assets are retail, recently this balance has seemed to be shifting.
The chart below addresses what type of unconstrained fixed income funds saw inflows of this institutional money. As a percentage of institutional assets at the end of 2014, alternative multi-asset credit funds have seen by far the most.
We predict strong growth of pooled unconstrained fixed income, from a current €171bn to €300bn in 2020, which implies a compound annual growth rate of 11.8 per cent.
I feel the last word should go to Maxim again. He says he expects “this growth to be fuelled in particular by perceived interest rate risk by investors, as rate hikes are likely to occur in the US, UK and eventually Europe in the coming years”.
Magnus Spence is managing director of Spence Johnson
