From the November 2007 issue of Wealth Manager Web • Subscribe!

November 1, 2007

Against the Grain

In July, multisector bond funds struggled, losing a percentage point. The trouble stemmed from concerns about subprime loans and a sluggish economy. Worried about defaults, investors dumped lower quality bonds of all kinds, including emerging market and high-yield securities--categories typically held by multisector funds. However, the multisector funds were saved from even bigger losses because they also own Treasuries and other high-grade issues, which stayed afloat in the turbulence.

Should investors steer away from multisector funds? Not necessarily. The funds provide diversified exposure to the bond markets. And with the outlook for fixed-income uncertain, diversification may be particularly important now. As the July market action demonstrated, one bond category sometimes rises when other areas are falling.

Besides providing diversification, many multisector bond funds have recorded strong long-term performances. During the past five years, the category has returned 8.9 percent annually--more than double the results for the average intermediate-term bond fund.

Which multisector fund makes the best choice? To find a winner, we turned again to the eight-part screens developed by Donald Trone, chief executive officer of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks to find funds that are at least three years old and have a minimum of $75 million in assets. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must also surpass category medians. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.

The screens reduced the field from 111 contenders to 28. Top performers included Franklin Strategic Income, Oppenheimer Strategic Income and Federated Strategic Income. We awarded the title to Loomis Sayles Strategic Income, which had the top five-year returns and the highest Alpha among the finalists.

Loomis Sayles achieves winning results by following a contrarian strategy--buying securities that others shun. In their search for bargains, veteran portfolio managers Dan Fuss and Kathleen Gaffney range widely, emphasizing shaky Thai bank bonds one year and high-grade U.S. corporate securities the next. The goal is to buy an undervalued security and hold it for three to five years, enough time for the bond to rebound from its trough. The fund often buys below-investment grade bonds that seem poised to gain higher quality ratings, a process that boosts security prices sharply.

When airline traffic dropped in 2002, the fund bought securities from Continental Airlines and American Airlines which were considered to be below-investment grade. "Many investors seemed to be fairly certain that the airline industry was going under," recalls Gaffney. "But it seemed to us that things would improve at some point."

For extra protection, the managers bought airline securities that were backed by planes and equipment. That way the investment would still have value--even if the airline companies went bankrupt. The investment proved timely. As economic conditions improved, the airline credit ratings rose to investment grade, and Loomis Sayles scored a big gain.

More recently, the fund has been buying bonds of companies that are being taken over in leveraged buyouts. The credit quality of such bonds often drops, because the companies take on heavy debt loads. Seeking a bargain, Loomis Sayles bought lower-quality bonds of Albertsons, the supermarket chain which was taken private in 2006. "Because the company and management are strong, we figured that they would be able to pay down debt and return to investment grade in a few years," says Gaffney.

To boost results, Loomis Sayles often bets on the direction of currencies. Lately the managers have been expecting the dollar to decline against foreign currencies. If that happens, the value of foreign bonds would rise for U.S. investors. To take advantage of any fall in the dollar, the fund has bought very high quality bonds issued by the Inter-American Development Bank and payable in the Brazilian real. Other holdings include General Electric securities that are payable in Singapore dollars.

Besides investing in foreign currencies, the fund also tries to gain extra returns by altering the maturities in the portfolio. From 1995 through 2002, the managers expected that interest rates would fall. To take advantage of the forecast, the fund held many bonds with maturities of 20 years or more. Prices of such long bonds rise sharply when interest rates drop. The strategy proved successful and helped increase the fund's returns.

After 2002, the fund emphasized short bonds. This year the managers are again holding longer bonds. The moves have proved profitable. "With growth slow in the U.S. now, we think that interest rates have peaked and will head down," Gaffney says.

The fund aims to have an average credit quality of at least BBB--Standard & Poor's lowest investment-grade rating. At the moment, the average credit is A, one rung up from the bottom of the investment-grade ladder. The current credit quality is higher than usual for the fund. The managers are worried that many low-quality securities are excessively priced, so the fund is emphasizing Treasuries and corporate bonds that carry the highest rating of AAA.

Shareholders of the fund should feel grateful that Loomis Sayles has been avoiding subprime and other mortgage securities. These have been suffering lately as the housing market weakens and defaults rise. The managers decided that mortgages did not pay adequate yields to compensate for the risks. That kind of successful call has long helped this fund avoid trouble spots and deliver strong returns.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a New York-based freelance business writer and a longtime regular contributor to Wealth Manager.

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