Will new niche funds protect bond investors?

Here's a quandary for retirement investors: They're being told that bonds are probably headed for a long, slow and potentially painful decline as the Federal Reserve ends its easy money policies and interest rates start to rise.

But they are also told that they should keep some of their money invested in the bond market if they want to be prudently diversified. And so, how do they deploy those fixed-income assets without getting slammed when that widely-predicted bond bear hits?

The fund industry thinks it has a few ideas, and is serving up a couple of niche offerings that it says will allow investors to eke out respectable returns without being overexposed to severe price declines.

The relatively new products span the extremes of the management spectrum. There are unconstrained bond funds that let managers buy whatever they want whenever they want, and there are exchange-traded bond funds that tie managers hands to a very narrow band of bonds that they are held until they mature.

In both cases, the theory is that these newish funds (the oldest is 3 years old) will provide investors with better income than the almost non-existent yields available in very short-term securities, but will buffer them from the share price declines that could hit if rates rise.

REPRESENTING EXTREMES

"They are attracting a lot of attention and a lot of chatter," says Jeff Tjournehoj, head of Lipper Americas Research, a Thomson Reuters company. "These two represent the extremes because there are so many varying opinions about what happens next and what to do about it as an investor."

Here's a look.

The first unconstrained bond fund was created by bond powerhouse Pimco in mid 2008. Since then, the Pimco Unconstrained Bond Fund (PUBAX) has attracted more than $17-billion in assets, and been joined by a handful of competitors -- including no-load Harbor Unconstrained Bond Fund (HAUBX), the JPMorgan Strategic Income Opportunities (JSOAX) and the AllianceBernstein Unconstrained Bond Fund (AGCCX).

"It's one of the hottest segments of today's mutual fund market," writes Morningstar analyst Eric Jacobson.

The theory behind these funds is that nimble and knowledgeable managers, given the widest possible latitude to buy, sell, or even short whatever segment of the bond market they'd like, will produce reliably steady returns that are higher than a short-term bond index. The managers of these funds can buy corporate bonds, sovereign debt of emerging market countries, or high yield debt.

FLEXIBILITY PAYS OFF

Most of these funds haven't been around long enough to build useful performance histories. The handful that have been around for a year averaged 3.76 percent in the 12 months which ended on May 18, according to Lipper. In comparison, the iShares Barclays Aggregate Bond Fund (AGG), an index exchange traded fund (ETF) which covers the U.S. investment grade bond market, returned 4.88 percent during that period.

The theory is that the flexibility of these funds will pay off when rates rise. These managers will be able to get out of the way of falling prices when rates rise, in a way that a broad bond index fund could not.

But that's still an untested theory.

Morningstar also notes that these funds aren't cheap. With a median expense ratio above 1 percent, the funds would have to solidly outearn cheaper and more constrained short-term funds over the long term.

The rap on bond funds is this: Their holdings turn over constantly, so they never really mature like individual bonds. When rates rise, their prices decline, and investors who have to sell may not get their money back.

Individual bond prices can decline too, but investors know that if they hold their bonds until maturity, they'll get their face value investment back.

But it takes a fair amount of money and time to amass and manage a safely diversified portfolio of corporate bonds.

FILLING HOLES IN CORPORATE BOND PORTFOLIOS

Enter Guggenheim Bulletshares, launched in June 2010 to provide investors with a "permanence in definition in their bond investment strategy and exposure," according to David Botset, senior vice president of product development for Guggenheim.

He says investors, who have put $400 million into the funds in less than a year, are using them to fill holes in their own individual corporate bond portfolios, or as parking places while they decide which individual bonds to buy going forward.

The Bulletshares include 7 investment-grade corporate bond funds and four high-yield bond funds, ranging in maturity from 2011 (BSCB) through 2017 (BSCH).

BlackRock Inc. also offers fixed-maturity muni bond funds, the iShares S&P AMT-Free Municipal Series, which currently run from 2012 (MUAA) to 2017 (MUAF).

In all cases, the ETFs will liquidate on their maturity date, and investors will get the net asset value for their shares on that date.

There's still no guarantee that their entire principal will be returned, but since the funds mainly consist of bonds which mature on that date (and shorter-term investments to fill holes), backers suggest that investors will have more certainty than they would with open-ended portfolios.

These ETFs do have low fees that compete well with more open-ended bond funds, says Lipper's Tjournehoy, and they are likely to attract some investors and money managers who like the fixed maturity date.

But not every investor will stay till the bitter end, he notes.

Investors who sell these ETFs before their end date would find themselves in the same situation as investors selling any other open-ended bond fund; they could end up selling at lower share prices and losing some of their initial investment.

(Reporting by Linda Stern; Editing by Bernadette Baum)