Quick Take: The two top-performing high-quality bond funds for 2003 were both managed by Loomis Sayles & Co. Loomis Sayles Fixed Income Fund (LSFIX), managed by Daniel Fuss, and the Loomis Sayles Bond Fund/Instl (LSBDX) , co-managed by Fuss and Kathleen Gaffney, posted returns of 30.2% and 29.2%, respectively. The two funds are almost identical in investment objective and management style.
The funds’ benchmark, the Lehman Government/Credit Bond Index, gained only 4.7% for the year. For the three-year period ended 2003, the Bond Fund gained an average annualized 14.6%, while the index returned 8%.
Ranked 5 Stars by Standard & Poor’s, the Bond Fund’s 0.75% expense ratio is significantly below its peer group’s 1.28% average. While the fund began operations in May 1991, Gaffney joined the management team in November, 1997.
The Full Interview:
S&P: What do you attribute the Loomis Sayles Bond Fund’s outperformance to in 2003?
GAFFNEY: Our outperformance can primarily be attributed to our significant exposures to the lower-quality tiers of corporate bonds, and to our investments in high-yield securities and non-dollar-denominated bonds.
The market today represents almost a complete reversal of the climate we had a year ago — back then, we witnessed a flight to the quality and safe haven of bonds. Since that time, central banks around the world have provided a lot of liquidity, and that liquidity moved to the more aggressive and higher-yielding segments of the securities markets.
Overall in 2003, our strong returns were driven by currency issues, and by the narrowing of corporate spreads.
S&P: How much of the fund can be invested in higher-yielding or lower-quality bonds?
GAFFNEY: We are allowed to invest up to 35% of our fund’s assets in higher-yielding, lower-quality bonds (it’s currently at 32.3%). Of this high-yield component, roughly one third is in emerging market bonds, or about 12% of the fund’s total assets. We can also keep up to 20% in non-dollar denominated bonds; and another 20% in Canadian bonds.
S&P: How large is the fund now? What are some of its other characteristics?
GAFFNEY: As of December 31, the $2.2-billion fund comprised 295 holdings. The top ten holdings accounted for 31.2% of the portfolio’s total assets. The fund has an annual turnover rate of 33.5%, a weighted average duration of 6.5 years, and an average maturity of 11.00 years.
S&P: Why did high-yield and emerging market bonds perform so well in 2003?
GAFFNEY: Part of it was due to investors’ renewed appetite for higher-risk investments, and we saw record cash inflows into these asset classes. This is the polar opposite of where investor sentiment was one year ago.
With this increased liquidity and more optimism about the global economy, bond investors sought out higher potential returns from higher-yielding and higher-risk securities. High yield bonds also benefited from lower default rates, while the positive outlook for the global economy greatly helped emerging market bonds.
S&P: What corporate sectors of lower quality have you been investing in? Telecom and electric utilities, perhaps?
GAFFNEY: While we do have exposure to telecom and utilities, which also contributed to our out-performance in 2003 due to their rebound, we are quite diversified. We also have significant allocations in technology bonds, including some convertibles, which we view as a “high-yield substitute.”
S&P: Do you expect the Federal Reserve to raise interest rates this year? If so, how are you positioning the fund for 2004?
GAFFNEY: With the yield curve so steep and with yields so low, we feel interest rates are bottoming. We expect the Fed will hike rates by a total of 75 basis points by the end of the year. Most likely, these will be incremental increases in the second half of 2004.
However, a 75-bps rise is relatively modest. Rates would have to be boosted much higher before high-yield and emerging market bonds started to underperform. Thus, we’re still optimistic that these two asset classes will continue to deliver strong returns in 2004.