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Kathleen Gaffney of Loomis Sayles Strategic Income Fund

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Quick Take: The $662-million Loomis Sayles Strategic Income Fund/A (NEFZX) considers any government or corporate bond in the world that is undervalued by the market. Co-managers Daniel Fuss and Kathleen Gaffney seek broad diversification throughout the fixed-income universe.

For the one-year period through August, the fund rose 17.0%, while the average global multi-sector bond fund gained 10.0%. For the three-year period, the fund returned 16.1%, annualized, versus a 9.2% rise by the peer group.

The fund has a low turnover rate of 27%, versus 154.7% for the peer group. However, its volatility, as measured by standard deviation, is higher than its peers, 8.39 versus 5.66.

Gaffney joined the fund’s management team in April 1996. Fuss has managed the fund since its inception in May 1995.

The Full Interview:

S&P: What type of bonds do you invest in?

GAFFNEY: This is a multi-sector fixed-income fund with a broad mandate. Essentially we can invest in corporate and sovereign debt anywhere in the world across the credit quality spectrum. However, most of our holdings tend to be U.S. government bonds, other high-quality government bonds, U.S. corporate debt (both investment-grade and high-yield), and emerging-market debt.

If we see value in other sectors, like municipal bonds, mortgage-backed securities, or TIPS, we also invest there.

Regardless of the category, we seek undervalued bonds with a yield advantage relative to the market and strong prospects for price appreciation.

S&P: What are the benefits of investing in multi-sector bond funds?

GAFFNEY: Multi-sector bond funds provide a good complement to the vagaries of the broader fixed-income market. Given rising interest rates, many bond investors realize the best approach is flexibility and diversification across different sectors.

The fund currently has about 225 holdings. We are strongly diversified, since we take on some credit risk and and illiquid holdings. The more holdings we have, the better we can manage our illiquid investments.

S&P: Do you use a top-down approach?

GAFFNEY: Our process is strictly bottom-up, however we consider the economy and interest rates. Our starting point is always the U.S.

S&P: What is your current view of interest rates, and how does that affect your process?

GAFFNEY: The secular trend of declining interest rates is definitely over, so U.S. Treasuries are not attractive. But, U.S. corporate bonds are attractive because the transition from declining rates to rising rates does not happen overnight. This transition is all about growth — we have good economic growth in the U.S., but it’s not strong enough to cause a significant back-up in rates. We expect inflation to remain benign and economic growth to stay moderate. This is a good time to buy corporate bonds, especially those with good yields. Thus, we are very bullish on the U.S. high-yield market.

With respect to investment-grade U.S. corporate bonds, we especially like the upper-end of the lower-quality issues, like triple-B and single-A.

S&P: Do you limit individual positions or sector weightings?

GAFFNEY: We limit individual holdings to 5% of total fund assets, but we don’t limit our sector allocations. For example, high-yield bonds now represent 50% of our assets.

S&P: The fund surged almost 34.2% in 2003. What drove those returns?

GAFFNEY: In large part, we performed well last year because we held onto the bonds that were beaten down the prior year. When liquidity returned to the market in 2003, the fund flourished. Our exposure to high-yield and nondollar-denominated bonds also served us very well.

S&P: How has your high-yield exposure changed in the past few years?

GAFFNEY: It has been relatively steady, with our high-yield exposure ranging from 40% to 50% over the last two years.

S&P: Does your high-yield weighting lower your overall credit quality?

GAFFNEY: The bulk of our high-yield allocation is in U.S. high yield, and the remainder is in emerging-market debt. However, our fund’s average credit quality is BAA-2, which gives us an investment-grade rating overall. Our high-yield holdings also give us a barbelled credit quality profile.

As of August 31, we had 23.2% of our assets in AAA-rated securities, 9.6% in AA-rated, 6.3% in CAA, 31.2% in B, and 13.0% in BA.

S&P: What high-quality areas are you investing in?

GAFFNEY: Since we currently avoid U.S. Treasuries, our highest-quality investments are in nondollar-denominated bonds, or 38% of the fund’s assets, including 16% in the Canadian dollar, with the remainder in developed nation currencies, like the New Zealand dollar, the euro, the pound sterling, all strong currencies relative to the U.S. dollar.

The majority of our U.S. corporate bonds are currently high-yield, and only 2% are investment-grade since spreads have compressed so much.

S&P: How much exposure do you have to emerging-market debt?

GAFFNEY: Over the past five years, our exposure has been roughly 20%, with half in high yield and the other half in investment grade. There is a misconception that emerging market debt is synonymous with low credit quality, but this is untrue as emerging markets have matured. We have heavy exposure to high-quality bonds in Mexico and Chile.

As of August 31, our top country allocations were the U.S., 54.0%; Canada, 17.7%; Venezuela, 4.0%; and Mexico, 3.8%.

S&P: What are your sell criteria?

GAFFNEY: We generally sell when a holding reaches fair value or when the credit is expected to worsen.

However, we don’t buy and sell much, so our annual turnover is only 27%. We are patient, value investors, who can endure some short-term volatility. We buy a bond when we think it’s cheap and we hold onto it, perhaps through some turmoil, until the marketplace catches up to it in terms of valuations.

S&P: How are you positioning the fund for rising interest rates?

GAFFNEY: In this environment, it’s all about yield and security selection. The dispersion of returns will be lower across all fixed-income asset classes, so we need yield advantage and credit positions that we think will outperform on a company-specific basis.

S&P: Have you been surprised by how well bonds have performed this year?

GAFFNEY: I’m not that surprised because much of the returns come from yield. Our fund is up 3.0% this year through the end of August, while most equity indexes are flat or in the red. To some extent, the real economy is struggling because it lacks pricing power, which is hurting corporate profit margins and stock prices. As such, the Fed doesn’t need to raise rates sharply. Moreover, as inflation remains benign, this is a pretty good climate for high-yield bonds.

At this juncture, spreads have tightened in investment-grade U.S. corporate bonds, so they have little upside potential. To get outperformance, investors will likely have to take some credit risk with high-yield bonds, or foreign currency bonds on the premise that the U.S. will continue to need a weak dollar to maintain its economic recovery.

Contact Bob Keane with questions or comments at: [email protected].