Investors crave yield, but bond fund managers desire flexibility. A new breed of unconstrained bond funds may offer the best of both worlds.

The market’s volatility during the past year hasn’t quite risen to the levels seen at the height of the credit crisis. But investors have been whipsawed by bad news from almost every corner of the world. High levels of inflation in China and Brazil, a spreading debt contagion in Europe, natural disasters across the globe and a contentious debate in Washington over the US debt burden have rattled global markets.

This uncertainty has weighed upon bond investors who depend upon sound macroeconomic forecasts to make their investment decisions. But this year economists and market watchers of all stripes have been confounded by unforeseen events. Unsurprisingly, bond funds’ cash balances have swelled as managers wait out the uncertainty.

Most bond funds are constrained by an investment mandate or benchmark. Many funds are required to invest in certain segments of the bond market or a specific geography. In this environment, many managers would rather hold onto cash than take their lumps in a wildly unpredictable market.

Although most investors respect their fund manager’s judgment shareholders don’t pay management to sit on their hands. Heightened market volatility notwithstanding, most bondholders still require yield to meet their investment goals. And inflation inevitably erodes the value of cash holdings.

The mutual fund industry has sought to split the difference between yield-seeking investors and fund managers that need flexibility in tough markets by offering a new breed of go-anywhere bond funds. Over the past three years, the universe of unconstrained bond funds has grown from a handful of market oddities to 15 funds with about $40 billion in assets.

PIMCO Unconstrained Bond D (PUBDX) is one of the most appealing of this new crop.

Running an unconstrained bond fund is a herculean task and investors must trust the fund’s leadership.

Manager Chris Dialynas has been with famed investment house PIMCO since 1980 and has risen through the ranks to become one of PIMCO’s managing directors and a member of the outfit’s investment committee. He works closely with PIMCO bond gurus Bill Gross and Mohamed El-Erian and can draw upon their wealth of expertise.

The fund’s go-anywhere mandate allows it to build a portfolio with a duration of minus-three years to eight years. Duration is a measure of interest rate sensitivity; a minus-three year duration means that the fund theoretically stands to gain as much as 3 percent for every 1 percent rise in interest rates.

Although the fund’s performance since inception hasn’t been stellar–its three-year return clocks in at 7.3 percent–the ability to run a negative duration will prove extremely beneficial in the coming months. The US Federal Reserve has made a commitment to keep the lid on interest rates for the foreseeable future, but rates are rising in other markets.

Furthermore, if US fiscal and monetary authorities fail to take decisive action to reduce the bloated budget deficit, the markets are likely to push US rates higher, regardless of the Fed’s intervention.

The fund can also make unlimited investments in non-dollar denominated securities, an added flexibility that will prove beneficial when the US dollar weakens–an outcome that’s all but certain given the significant pressures facing the currency.

The fund is likely to face challenges in the future, however, and management has already made missteps. Dialynas decided to short the euro just as the currency rallied against the dollar; PIMCO also sat out last year’s rally in US Treasury bonds.

The fund sports a fairly high annual expense ratio of 1.30 percent, though the price tag may be reasonable given the fund’s extensive use of derivatives.

Every fund has its drawbacks and PIMCO Unconstrained Bond D is no exception to the rule. But the fund should prove a useful holding for investors amid a challenging bond market.