April 17 (Bloomberg) -- During tricky times in the bond market, the team at Loomis Sayles, renowned for their mastery of the unconventional, is a top-notch tour guide. The $19 billion Loomis Sayles Bond Fund and $13 billion Loomis Sayles Strategic Income operate with long leashes that allow them to sniff around just about anywhere: Junk bonds, foreign issues, convertible bonds, preferreds and dividend-paying stocks can all be added to the portfolios to augment the conventional stuff.
That flexibility gives them a yield edge: The 5.9 percent yield at Strategic Income is double the payout for the benchmark bond index, the Barclay’s Aggregate U.S. Bond Index. The 5.6 percent yield of the retail shares for Loomis Sayles Bond is also well above the sub-3 percent income payout for the index over the past year. The funds have done well over the long run as well. For the past decade, the 11 percent annualized return at both funds ranks in the top 10 percent of similar funds, according to Morningstar.
To be sure, the U.S. Treasuries and high-grade corporate issues that the benchmark bond index gorges on provide ballast during rocky markets. To add some incremental yield in today’s low-rate world, though, requires stepping outside the indexing box. In fact, in Loomis Sayles's case, it increasingly means stepping out of conventional bonds and focusing more on higher-yielding stocks.
Outside the Box
Neither Loomis Sayles portfolio will win any index look-alike contests compared with peers. For starters, the funds currently do not own any U.S. Treasuries. Nada. By comparison, 35 percent of the Barclays Aggregate index is tied to Treasuries. “There’s just no return there,” says Kathleen Gaffney, a co-manager of both funds since 1996, alluding to the less than 2 percent yield on a 10-year Treasury. “And there is tremendous amount of risk with Treasuries once yields start to rise.”
Gaffney is quick to point out that the inevitable rise in yields may not happen this year, or even next. And she acknowledges the obvious: Forsaking Treasuries certainly didn’t pay off last year, especially in the risk-off environment of the third quarter. Both funds lagged the Barclays index in 2011 by about 3 percentage points. But Loomis Sayles has always kept its focus firmly on the long term at the price of being smacked around over shorter periods.
“Now is the time to get prepared for rising rates,” says Gaffney. “We want to earn yield today, but we are looking for bonds that can go up in price when yields rise.”
That puts the kibosh on U.S. Treasuries, the most rate-sensitive of investments. (When yields rise, the price of conventional high-quality bonds falls. Total return is the combination of yield plus the change in the underlying price of a portfolio’s bonds.)
Both funds have 15 percent or so of assets in foreign government bonds, with Canada the largest country allocation. Overall, both funds have about one-third of assets in non-dollar currencies. “If inflation becomes an issue and the U.S. dollar weakens, foreign currency investments will give us the opportunity for higher total returns,” says Gaffney. The Barclays Aggregate index invests solely in U.S. dollar-denominated bonds.
The bulk of the two go-anywhere Loomis Sayles funds is in corporate bonds. Unlike the Barclays Aggregate index, which by mandate sticks to investment grade issues, Loomis Sayles has built a decided tilt in lower-quality bonds. Nearly half of Strategic Income’s bond portfolio is invested in below-investment grade or unrated issues; at Loomis Sayles Bond the junk/unrated stake is near 30 percent.
That’s in keeping with the team’s focus on bonds that can make money even when rates rise. Junk bonds tend to be more sensitive to what’s happening in the economy than to the direction of interest rates. If rates begin to rise because of sustained economic growth, that’s good news for junk bond issuers who should have an easier time making good on payments.
The funds also have another 8 percent of assets tucked into convertible bonds that, like standard junk issues, are less rate-sensitive. They “give us the opportunity for price appreciation when rates rise,” says Gaffney.
The Loomis Sayles team is also adding equities. Strategic Income’s 16 percent stake in dividend-paying common stock is a record for the fund. It also has another 3 percent in preferred stock.
Top five holdings at both funds include Intel’s common stock, which has a 2.9 percent dividend yield. Spain’s Telefonica S.A., with a 13.9 percent yield, is the second-largest holding in Strategic Income. Like many Euro-based investments, it has been pulled down by the debt crisis, but Gaffney says the team is cherry-picking European companies in telecom and utilities industries for their recession resilience and solid fundamentals.
“We’re looking at large-cap, global companies that can increase their market share and where we expect earnings to grow, and therefore dividends to grow as well,” says the manager. That’s a recipe for both strong income today and strong total returns over time. Even when rates rise.