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Playing Defense, Scoring Big

By Palash R. Ghosh Bond funds are suffering cash outflows as investors become spooked by rising interest rates in the U.S. But some fixed-income fund managers can minimize losses, and even find positive returns, by diversifying their assets with an array of bond issues from around the globe.

Multisector bond funds have several advantages over regular fixed-income portfolios: They can invest across the broad spectrum of bond asset classes in allocations that reflect the portfolio manager's expectations for relative outperformance, as well as his risk-reward perspective. The Putnam Diversified Income Trust/A (PDINX) is such a fund.

The $5-billion portfolio gained 5.61% for the one-year period ended Mar. 31, 2005, vs. a return of 5.32% for its fixed-income global multisector fund peers. For the three-year period, the portfolio registered an annualized return of 10.7%, edging out similar funds, which climbed 10.35%. For the five-year period, the portfolio surpassed its peers again, rising 7.31%, vs. 7.21% for the average global multisector bond fund. (Based on risk and return characteristics over the last three years, Standard & Poor's ranks the fund as 4 STARS overall.)

PREP FOR THE DOWNSIDE. Boston-based D. William Kohli supervises a team of portfolio specialists -- Rob Bloemker, Jeffrey Kaufman, Paul Scanlon, and David Waldman -- who help construct the portfolio. Choosing from a long menu of fixed-income securities -- primarily investment-grade bonds, high-yield corporate bonds, and foreign bonds -- the fund managers determine an appropriate asset-allocation profile based on, among other factors, the outlook for interest rates, and the relative attractiveness of various bond sectors. After that, individual security selection is strictly a bottom-up affair.

"From a multisector perspective, our fund has done well because we have adhered to a defensive posture in the high-yield market, in emerging-markets bonds, and with respect to

duration," says portfolio leader Kohli. "Regardless of market environment, our basic philosophy lies with broad-based asset allocation. We want as many sources of ongoing returns as possible so no one particular event or development can damage the fund's overall performance. Whether or not rates keep rising or credit spreads widen, our defensive, diversified strategy will protect us from downside."

The fund has shown below-average volatility recently, and below-average

turnover relative to its peers. The

expense ratio on the portfolio is 0.95%, also below the peer-group average of 1.32%. In addition, the fund recently reduced its

front-end load to 3.75%, from 4.50%.

NO PRESET LIMITS. By geography, U.S. bonds represented the lion's share of the fund's assets (77.3%) as of Mar. 31. The remaining assets were spread across 32 different foreign nations, both developed and emerging, with no individual foreign market accounting for more than 3.4% of total assets. Kohli explained that while many overseas bond markets can provide rich returns, some of their illiquidity, volatility, and fragile credits make broad diversification an imperative.

After racking up gains of 18.97% in 2003 and 9.13% in 2004, the fund has edged down 0.44% through the first three months of 2005, while the peer group has dropped 1.12%. Gains in 2004 were attributable to euro bonds, high-yield bonds, and emerging-markets securities outperforming. Since then, Kohli has scaled back his exposure to both emerging markets and high yield, largely to valuation concerns.

As of Mar. 31, the fund's top sector allocation, high-yield bonds, represented 36.8% of total assets, followed by mortgage-backed securities, 18.6%; government bonds, 11.6%; asset-backed securities, 10.63%; and emerging-market bonds, 6.65%. Kohli imposes no artificial or preconceived limits on the fund's asset allocation. For example, his exposure to high-yield bonds was as high as 65% at one point.

TOUGH SLEDDING AHEAD? Despite scaling back his exposure, Kohli remains enamored with good quality high-yield bonds, noting that they continue to benefit from declining default rates, attractive yield advantages over government bonds, and healthier corporate balance sheets. Still, the managers aspire to maintain an overall investment-grade quality in the portfolio -- but credit quality can range from the highest (AAA, which currently accounts for 39.5% of total assets) to as low as CCC-rated issues.

Reflecting the fund's ability to diversity its assets, Kohli uses one primary benchmark: Lehman Aggregate Bond Index, and two secondary benchmarks, Citigroup Non-U.S. World Government Bond Index and the J.P. Morgan Global High-Yield Index.

With interest rates moving up sharply, and credit spreads widening, Kohli said most fixed-income assets are facing a difficult environment. One asset class that has outperformed in recent years, international bonds, may also start to struggle as the U.S. dollar appears to be slowly recovering from multiyear weakness, he added. U.S. government bonds, Kohli said, are likely to remain underweight in the fund while the Federal Reserve continues to be firmly committed to hiking interest rates. Ghosh is a reporter for Standard & Poor's Fund Advisor

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