Forecasting for Dollars

Many bond funds prefer not to bet on the direction of interest rates. Here are a few that do - and win.

Bond fund managers at Fidelity Investments once considered themselves the fixed-income counterparts of Peter Lynch. Like the master of Fidelity Magellan, the bond specialists would sometimes go against the crowd, placing big bets on their convictions. But the free-ranging style proved difficult to execute in the fixed-income arena. In an effort to best their peers, many bond funds sought to forecast the direction of interest rates, and most bond managers — as well as Wall Street economists — missed the mark.

In the 1990s, Fidelity's management decided to throw in the towel. Bond fund managers would no longer gamble on the direction of interest rates. Instead they would try to gain an advantage over peers by making minor adjustments, picking the best individual bonds or perhaps favoring a security with a three-year maturity over an alternative with a maturity of four years. The change worked wonders: Fidelity managers began to hit plenty of singles and doubles — while avoiding strikeouts. Many funds went from being also-rans to above-average performers. Fidelity gained a reputation as a strong bond family.

Now the Fidelity approach has been adopted widely. Managers aim to track their benchmarks closely and add value by tinkering at the edges. “Most funds we see keep their interest rate bets to a minimum,” says Scott Berry, a Morningstar analyst.

Making Bets

For many investors, this cautious approach is fine. But some clients may prefer one of the few funds that still aims to stand far out from the pack. These active managers use a variety of tools. Some overweight sectors, emphasizing mortgages this year and corporate bonds next. A few funds make interest-rate bets. When rates seem headed down, the fund managers buy bonds with longer maturities, hoping to achieve sharp capital gains. When rates seem poised to rise, the managers shift to shorter-term securities. These suffer small losses during periods of rising rates. “By looking intelligently at rate forecasts, a good manager can add value,” says Paul Coldagelli, a financial advisor with Landaas & Company, a registered investment advisor in Milwaukee.

A top-performing active fund is Loomis Sayles Bond, which has outdone 96 percent of its competitors during the past decade. Portfolio manager Dan Fuss ranges widely, emphasizing Thai bank bonds one year and U.S. mortgages the next. Fuss sizes up the long-term outlook for interest rates and places his bets. During the 1990s, the Loomis fund had an average maturity of 20 years, a position that produced nice profits as rates dropped. Then in 2002, Fuss lowered the average maturity to about seven years. With the government running big budget deficits, the portfolio manager figured that bond yields were bound to rise. “We thought interest rates were going to bottom out and then begin trending upward for a period that could last 20 years,” says Fuss.

Loomis Sayles was a bit early in shortening maturities, but so far the fund's forecast seems to be uncanny. In the summer of 2003, yields on 10-year Treasuries hit their lowest level in four decades, and since then rates generally have headed upwards.

Another fund that has shined by using a variety of tools is Metropolitan West Total Return. While the fund focuses on investment-grade issues, it sometimes boosts yields by buying high-yield bonds or lower-quality bank loans. Worried about rising short-term rates in 2005, the Metropolitan portfolio managers turned defensive. To reduce interest-rate risks, Metropolitan built a so-called barbell portfolio, with assets focused on short- and long-term bonds; the fund de-emphasized intermediate securities. “When rates are rising, a barbell will typically outperform a conventional portfolio,” says Chris Scibelli, managing director of Metropolitan West Asset Management.

The barbell move proved successful. Throughout the year, the Federal Reserve raised short-term rates. Intermediate rates rose while long rates stayed relatively flat. Thanks partly to its emphasis on short-duration securities, the fund avoided big losses and outdid 97 percent of its competitors for the year.

Pioneer Strategic Income has scored strong returns by holding a mix of high-yield and investment-grade issues. The fund overweights bond sectors that seem to be selling at bargain levels. Pioneer began emphasizing high-yield bonds in 2002. At the time, default rates were high, and investors bid down prices of shakier high-yield issues. Portfolio manager Kenneth Taubes became convinced that the bonds had been knocked down too far. With the Federal Reserve cutting interest rates, the economy seemed poised to improve. “There were indications that corporate profits would strengthen and that would lower default risk and help raise high-yield prices,” says Taubes.

The forecast proved accurate, and high-yield prices have risen. This year, Taubes worries that the economy may slow down soon and put pressure on corporate profits. For more security, he is cutting back on high-yield issues and shifting to Treasuries that could weather harder times.

During the past five years, Eaton Vance National Municipal has outdone 99 percent of its competitors by making contrarian moves. The fund loves to grab bonds that seem to have been unfairly punished by the markets. For example, when California voted to recall its governor in 2003, investors worried about the Sacramento budget and the state's bonds suffered. Eaton Vance scooped up the issues and scored big gains when they recovered. “We figured that the problems in California were a temporary situation that would soon be cleared up,” says portfolio manager Thomas Metzold.

When Metzold worries about rising interest rates, he sometimes hedges his portfolio by selling Treasury futures short. The value of the futures rises as bond prices fall. Metzold sold futures in the summer of 2005 and scored gains that helped him race past competitors.

Like Eaton Vance, Columbia Tax-Exempt often goes against the crowd, buying unloved bonds. In 2003, portfolio manager Kimberly Campbell began to worry that tax revenues in some states might slow. That would hurt general obligation issues, which are backed by taxes. Campbell moved away from some high-priced general obligation issues and emphasized bonds that were backed by steady revenue sources like toll roads. The trade worked as prices of general obligation issues softened.

Currently, Campbell is not looking for any great rise in interest rates and she is emphasizing long bonds, a strategy that few competitors are matching. “We think inflation will be relatively muted, and that should bode well for fixed income,” she says.

Bond Funds That Place Bets On the Direction of Interest Rates
Fund Ticker 1-year Return 3-year Return 5-year Return Category % Rank 5-year Return Maximum Front Load
Columbia Tax-Exempt A COLTX 3.1% 5.3% 5.1% Muni Long 12% 4.75%
Eaton Vance National Municipal A EANAX 6.8 8.7 7.8 Muni Long 1 4.75
Loomis Sayles Bond LSBRX 6.9 13.8 11.3 Multisector 6 0
Metropolitan West Total Return MWTRX 2.8 7.2 5.5 Intermediate 24 0
Pioneer Strategic Income A PSRAX 3.1 10.4 9.3 Multisector 9 4.5
Source: Morningstar. Returns through 1/31/06.
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