Loomis Sayles Bond Preps for Rising Interest Rates

The managers at Loomis Sayles Bond (LSBRX), a member of the Kiplinger 25, appreciate good values and have the latitude to go anywhere to find them, whether it's in fixed-income securities, convertible bonds, bank loans or even common stocks. But the managers — Dan Fuss, Elaine Stokes and Matt Eagan — also have to keep an eye on the bigger picture. These days, with yields near historical low levels across nearly all types of bonds, they're building a portfolio that's poised for a rise in interest rates.

The managers continue to find deals in high-yield corporate bonds, which account for 19% of their fund's assets. And about one quarter of the portfolio is invested in securities that are issued in foreign currencies, such as Mexican pesos, Australian dollars and Norwegian krone. One purchase in 2012: Morgan Stanley bonds issued in Australian dollars. Those particular securities pay a yield of 8%, which is higher than the U.S. dollar-denominated Morgan Stanley bonds also held in the portfolio. Finally, the fund has acquired some convertibles (bonds and preferred stocks), straight preferred stocks and common stock of high-quality dividend-paying companies, such as Intel and Bristol-Myers Squibb. "If rates head up," says Stokes, "that's generally good for equities."

Stokes and her cohorts have been right about many things in years past, as their long-term record shows. Over the past decade though February 15, Loomis Sayles Bond returned an annualized 9.7%, an average of 4.6 percentage points per year better than Barclays U.S. Aggregate Bond index, a measure of the broad U.S. bond market. Over the past year, the fund earned 10.8%, beating its bogey by a whopping 8.1 points.

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But there have been a few bumps along the way. In 2008, a heavy weighting in corporate bonds dragged the fund down 22.1%. That year, Bond lagged the Barclays index by 27.4 percentage points. In 2011, the fund returned 3.5%, lagging the index by 4.4 points. The main culprit this time: almost no Treasuries in the portfolio. Those bonds rallied strongly in the second half of 2011 as frightened investors piled into what they perceived to be the safest IOUs on the planet.

Another bump came in 2012: In October, Kathleen Gaffney, a 28-year Loomis Sayles veteran and a co-manager of the Bond fund, resigned from the firm. She left to join Eaton Vance and to lead a team of portfolio managers for a group of new multi-sector bond funds. Gaffney often handled calls from reporters and thus, to people outside the firm, she appeared to be a prominent voice at Bond.

But her departure isn't reason to sell shares in the fund right away. She was one of Bond's four managers, and for the past ten years, the fund has moved from a portfolio-manager-focused investment process to one that's more team-oriented, says Jae Park, Loomis's chief investment officer. Fuss, who is 79, launched Bond's institutional share class in 1991 (the retail share class came in 1996). Stokes, who has been with the firm for 25 years, and Eagan became co-managers in 2007. The fund's real team, however, stretches beyond the managers to the 40-odd traders, fixed-income researchers and analysts who help in the analysis, purchase and sale of fixed-income securities.

No one on the team expects rates to rise rapidly in the near future. Loomis expects the yield on ten-year Treasury bonds — 2.0% on February 15 — to reach 2.25% by year's end. (Kiplinger's forecast is the same.) Stokes adds that the firm expects the slow-growing economic environment to continue in 2013, with little inflation. Stokes says the country's deficit problem is a risk, one that may take a decade to iron out. The process, she says, "is going to be long and slow." Other issues nag the managers, too. Continuing volatility in emerging markets and political tension in the Middle East could pose problems. And there's the worry that China, which has stabilized and will post better economic growth numbers this year, can grow without government support.

The topsy-turvy economic and political world combined with low yields and the threat of rising rates and inflation makes the job of picking bonds challenging. Stokes, Fuss and Eagan buy with a long-term view of three to five years. But, says Stokes, "no single bond sector is cheap these days."

That's what makes the dig-deep research of Loomis Sayles Bond so appealing. "This is not a time for an index bond fund," says Stokes. "Look for bond funds that are flexible in what they can invest in, and look for managers who do their credit work."