Loomis Sayles Bond Looks for Bargains in the Junk Pile

Stripped to the basics, you can make money in bonds in two ways: You can lend money to a financially strong company (or country or other government entity) for a long time at what are currently historically low interest rates, or you can lend money to a financially weaker entity at higher interest rates.

The managers of Loomis Sayles Bond (symbol LSBRX) have put most of their chips on option number two. Elaine Stokes, one of the $22 billion fund’s co-managers, says she and her colleagues believe the yield on the benchmark ten-year Treasury bond will rise from its current 2.66% (as of September 24) to 4.5% to 5% over the coming three to five years. If that scenario unfolds, you won’t do much better than break even in supposedly safe Treasuries. And high-quality corporate bonds will do little better. “Long-term, high-quality bonds are one of the riskiest investments you can make today,” Stokes says. The Federal Reserve’s decision to delay tapering its bond-buying program doesn’t affect her view.

The best way to make money, Stokes says, is to buy high-yield debt—bonds that face some risk of default. The finances of junk bond issuers will strengthen gradually as the U.S. economy slowly continues to gather momentum, pulling the anemic global economy behind it.

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Loomis Sayles Bond has 22% of its assets in domestic corporate junk bonds. Stokes is particularly bullish on bonds in the housing, telecom and health care sectors. The fund has another 10% in convertible securities—hybrids that have characteristics of both stocks and bonds. Because of those stocklike characteristics, converts, like junk bonds, can rise in value even as interest rates rise. And 6% of the fund is in stocks.

In investment-grade bonds, the fund has a bent toward banks and some other financial stocks that can benefit from rising rates, as well as selected European bonds. Stokes sees no reason to be optimistic about Europe’s economy, but she’s finding some bonds of high-quality companies selling at cheap prices.

For its relatively safe money, the fund has about one-third of its assets in short-term bonds denominated in foreign currencies, particularly from such stable countries as Canada, New Zealand and Norway.

The fund has little in emerging-markets bonds—a weighting that the managers gradually reduced over the past two years. Stokes says that China’s conversion from an export-oriented machine to a more consumer-oriented economy is proving stressful. That, she says, has had a negative ripple effect on many other emerging markets, which are heavily dependent on commodity exports, particularly to China.

Loomis Sayles Bond has been one of the friskier fixed-income products since co-manager Dan Fuss launched it in 1991. It has always dabbled heavily in the risky corners of the bond market.

Over the long term, that has been a successful strategy, but there have been bumps in the road. Over the past ten years through September 23, the fund has returned an annualized 8.3%--almost double the 4.7% yearly return of the Barclays U.S. Aggregate Bond index. So far this year, the fund has gained 3.3%, compared with a 2.3% loss for the Barclays index. But in 2008, as the financial crisis pummeled all sorts of risky investments, Loomis lost 22.1%, while the Treasury-heavy Barclays index gained 5.2%. The fund’s retail shares currently yield 3.2%.

That points up a problem for investors. If the U.S. economy continues its current trajectory of modest growth—and I think that’s likely—the fund should do well. And your stocks probably will do well, too. But if the economy falters and slides into recession, your stocks almost certainly will lose money, and Loomis Sayles Bond could well fall, too.

So you give up some diversification and take on some added risk by owning this fund. In return, though, I think you’ll probably earn more—if you can afford to be patient.

Speaking of volatility, over the past five years the fund has been more than three times as volatile as the Barclays index and two-thirds as volatile as Standard & Poor’s 500-stock index. The bottom line: If you invest in this fund, you’re likely in for a bumpy, if ultimately rewarding, ride.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.