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A New Approach to Bond Investing

Making big-picture calls on the economy and bond market has proved problematic this year. Putnam says it's better to put the focus on individual bond selection.

This has been a humbling year for bond fund managers. Rising long-term rates, inflation jitters, the Fed on hold and slumping values of subprime loans are just some of the factors weighing on the bond market. Even star bond managers, such as Pimco's high-profile Bill Gross, have struggled to return 1% so far this year.

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Kevin Murphy, a managing director in Putnam Investments' fixed-income division ($65 billion under management), thinks the traditional model of bond investing is fundamentally outmoded. Managers such as Gross tend to make big-picture calls on the economy and bond market and invest accordingly. Sometimes they get it right; other times, such as this year, they make some bad calls.

Putnam has moved away from this top-down approach because it has concluded that today's diversity and complexity of the bond market is too much for one brain to handle. A company generally trades only one class of common stock, but it may have a dozen different bonds. How many bond managers really understood the risks in the subprime bond market? "The best way is to take away the star manager who makes all the calls," says Boston-based Murphy.

Instead, Putnam's approach is more like that of a bottom-up stock picker. Murphy describes the typical bond fund as 80% top-down calls and 20% bottom-up security selection. Putnam's approach is the reverse: 20% big picture and 80% bond selection. It makes lots of small bets in a diversified pool of securities that it believes have a high probability of paying off. "If you spend the time to analyze individual bonds, you can find hidden gems," says Murphy. An army of 110 bond specialists, separated by the sectors they focus on, drill down into individual issues.

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Putnam is a load family, but it also manages a number of closed-end fixed-income funds that trade like stocks on the exchange. Two diversified bond funds that have held up well this year and have good long-term records are Putnam Premier Income Trust (PPT) and Putnam Master Intermediate Income (PIM). Premier Income, which closed July 13 at $6.55 per share, sells at a 9% discount to net-asset value and yields 5.5%. Intermediate Income, which closed at $6.51, trades at a 7% discount and also yields 5.5%. Neither fund employs leverage.

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