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High-Quality Bond Funds -- Year-End 2003 Review

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Jan. 6, 2004 — After three years of dominance, bonds appear to have run out of steam. With equity markets rising around the world, economic conditions improving, and interest rates likely to rise, investors have been shifting assets away from fixed-income securities into stocks.

Indeed, according to data from the Investment Company Institute, taxable bond funds have witnessed net new cash inflow of $40.2 billion through the first 11 months of the year, a far cry from the record $117.3 billion posted for the comparable period in 2002.

Despite this reversal of fortune, the average high-quality bond fund still gained 4.5% in 2003, and only a handful of such portfolios showed losses, and moderate ones at that. In comparison, the average high-quality bond fund rose 7.1% in 2002.

Within the realm of fixed-income funds, high-quality bonds under-performed such vehicles as high-yield and emerging market bonds, reflecting investors’ renewed appetite for higher-risk investments.

“The best performance among high-quality bonds this year came from the lower-quality, investment-grade corporate bonds, particularly single-A and triple-B type issues,” noted Zane Brown, partner and Director of Fixed Income Investments at Lord Abbett. “This was because they provided higher income stream, and as investors found value in higher yield, they tended to bid up prices relative to Treasuries. Yield spreads started the year rather wide, they narrowed somewhat, particularly among the lower-quality corporate issues.”

The year’s top performing high-quality bond fund, the $421-million Loomis Sayles Inv Tr Fixed Income Fund (LSFIX), benefited from its ability to invest substantially portions of its assets in lower-rate corporate bonds, as well as high-yield and emerging markets bonds. Managed by Daniel Fuss, the portfolio featured an average credit quality of A- at the end of September. The year’s second best performer, the $2.1-billion Loomis Sayles Bond/Instl (LSBDX), is also lead managed by Fuss.

“At the start of 2003, economic conditions were poor and the fear of war in Iraq weighed on global markets,” said Gregory Serbe, manager of the Lebenthal Funds Taxable Municipal Bond Fd (LTMBX). “Consequently, investors sought out the safety of U.S. Treasury Bonds — and this shift lifted virtually all other classes of fixed-income assets. By the second quarter, as the economy appeared to be improving, investors started to understand that the historic low interest rates would eventually rise. Thus, bonds endured heavy selling pressure and the Treasury yield spiked upwards, peaking as high as 4.6% in early September, compared with a low of 3.1% in early June.”

Serbe believes, however, that even if interest rates rise, some corporate bonds may perform well in 2004 as the economy strengthens and concerns about corporate governance ease. “The risk premium has greatly evaporated,” he noted. “Given that the economy is getting better, investors might want to purchase corporate bonds with a wide risk premium, and they could see some nice price appreciation.”

– Palash R. Ghosh