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.
Moreover, a hike in interest rates, which implies a strengthening global economy, would likely lead to high-yield credits generating better cash flow, and also help them pay down their debt faster.
S&P: The fund’s average credit quality is A (as of Dec. 31, 2003). Is this lower than what the fund has historically kept?
GAFFNEY: Generally, the portfolio keeps an investment-grade profile overall. However, relative to the past two years or so, the A rating is a bit higher than what our credit quality has been. We have been emphasizing the lower-quality issues, like BBB-rated bonds, and maximizing our high-yield exposure.
Currently, the fund has a “barbell” construct with respect to credit quality. As of Dec. 31, 17% of the fund’s assets were invested in securities rated BBB+.
This reflects our belief that interest rates will rise this year: We are “long” in our spread products, while the triple-B’s and high-yields tend to be longer than the market. At the short-end, we are very high quality, but it’s mostly in non-dollar denominated bonds, not U.S. Treasuries.
S&P: The ten-year US Treasury yield hit a 40-year low of 3.1% in June, then rose to as high as 4.6% in early September, and closed the year at about 4.3%. Was 2003 an usually volatile year for movements in the yield?
GAFFNEY: Volatility was indeed high. This signaled to us that the bond markets were going through a bottoming process. Volatility is typically low when markets are momentum driven. Thus, with all this excess liquidity, a lot of speculative money was looking for higher-yielding investments. Volatility will drop when interest rates rise. But we look at such volatility as a way of shaking out value in the marketplace.
S&P: If the dollar remains weak in 2004, will you increase your exposure to non-dollar-denominated investments?
GAFFNEY: We currently have about 40% of our fund’s assets in non-dollar denominated bonds, all from developed regions like Canada and Western Europe. Our Canadian-dollar exposure totals about 19%, comprising about 9% in short Government bonds and about 10% in long Government bonds. Even on that short-end, we are still picking up 100 basis points relative to U.S. Treasuries.
We also have approximately 5% in the euro, 3.5% in Norwegian krona, and smaller exposures to the Swedish krona and British pound sterling.
Our exposure to non-dollar denominated bonds are almost at a maximum, and we expect to keep this high exposure there this year. We expect the U.S. dollar to remain weak and the euro to maintain its strength. We have no exposure to Japanese yen bonds, because there is no potential for yield pick-up there.
S&P: If inflation rises, will that lead you to invest in Treasury Inflation-Protected Securities (TIPS)?
GAFFNEY: We have no exposure to TIPS currently. Most observers expect inflation to rise a bit in 2004, and the TIPS markets have already priced in that expectation — as such, these securities are already fully or even overvalued. So, although inflation is on our radar screen, we’re not overly concerned about it.
S&P: Are you invested in mortgage-backed securities?
GAFFNEY: Although mortgage-backed securities outperformed U.S. Government bonds in 2003 because of their yield advantage, we currently have no exposure to mortgages because we don’t like their negative convexity characteristics. We find non-dollar denominated bonds more attractive on a fundamental basis.
S&P: What is your outlook for bonds in 2004? Would you recommend that investors reduce their allocation to fixed income securities in their overall portfolios?
GAFFNEY: We have a positive outlook for higher-yielding bonds due to the continued steepness of the yield curve, and for non-dollar denominated bonds due to the continued weakness of the U.S. dollar.
Corporate bonds should also perform well as the U.S. is scheduled to create additional supply of government bonds. However, I don’t expect to see the kind of returns from bonds as a whole that we saw last year.
Provided that individual goals or needs have not changed substantially, I would not recommend that investors dramatically lower their allocation to fixed income because there is still plenty of opportunity to be found in foreign bonds and lower-quality corporates. However, they might want to alter the composition of their bond portfolios a bit. For example, they may want to reduce exposure to intermediate high-quality bonds, as well as lower their exposure to U.S. government bonds.
–Palash R. Ghosh