(09/19/14) Multi-Sector Bond Bets

For nearly three decades, bond investors have enjoyed the tailwind of falling interest rates, driving a historic bull market in bond prices, observes Benjamin Shepherd in Personal Finance.

Many bonds are now likely overvalued even as interest rates have nowhere to go but up. That’s not to say that you should abandon bonds; they’re a critical component of a well-balanced portfolio.

They provide a greater degree of security than stocks in terms of preserving value while also generating a steady stream of income.

But in this type of environment, greater diversification across the types of bonds available and incorporating non-traditional, bond-like securities will likely go a long way toward wealth protection in the event of a rout in the bond market.

How to diversify? The easiest way to achieve that is by adding a multi-sector bond fund or funds to your portfolio. These funds typically can hold anything from cash and junk bonds to preferred stock and convertibles, plus everything in between.

We currently have one such fund in our portfolio, Osterweis Strategic Income (OSTIX). Its managers can buy corporate or government bonds, preferred stock, or convertibles.

Depending upon their historically wise analysis, they particularly like contrarian plays. They’ll buy bonds of companies that the market has left for dead, but—thanks to cash flows and growth prospects—emerge from the ashes.

Management thinks the current Treasury yields don’t offer adequate compensation in this low-rate environment and don’t give enough cushion against rising interest rates.

As a result, they have favored short-duration, high-yield bonds, which make up about 84% of the portfolio, as well as some convertible issues that account for 2.8% of assets.

They have also built up a cash position equal to 7.3% of the fund’s assets, largely as a cushion against any future correction. And while the managers have the flexibility to invest almost anywhere in the world, they have opted to keep most of their assets in US-based firms.

While those decisions have brought the fund’s yield down from its one-time high of almost 8% to its current trailing 12-month yield of 4.3%, its interest rate risk is extremely limited with an average effective duration of just 1.94 years, versus 2.6 years, on average, for other such funds.

That conservative management and low volatility has clearly been a drag on the fund’s share price, but makes it an excellent safe haven in potentially turbulent markets.

Those with a higher risk tolerance might want to consider adding Loomis Sayles Fixed Income (LSFIX) to their portfolios.

Like the folks at Osterweis, the team at Loomis Sayles expects that capital appreciation in bonds will slow in the near term as interest rates begin rising.

As a result, it doesn’t believe that there are any great values in the credit markets. But rather than pulling their horns in, they’ve embraced more risk.

While the fund’s average credit quality is BB, its average effective duration is 4.63 years, as it has incorporated longer maturities into its asset mix to pick up a slight boost in yield.

It also holds a much more diversified mix of securities with just 23.4% allocated to high-yield bonds and 20% of assets allocated to investment-grade bonds. Another 10.2% of assets are devoted to Treasury bonds and 10.8% are in Canadian bond issues.

Nearly 17% are devoted to non-North American bonds, again to pick up another yield boost, with the remainder of assets spread across convertible bonds and preferred securities. It also holds just 2% of assets in cash and equivalents, remaining almost fully invested.

Given management’s allocation mix, the fund is significantly more volatile than Osterweis Strategic Income and would take a much bigger hit when interest rates rise or if the bond market were to take a turn for other reasons.

But the team at Loomis Sayles has an excellent track record of bouncing back from those turns, with category topping returns of 9.2% over the past ten years and 9.7% over the past 15 years. So, if you can stomach the higher volatility in the meantime, its investors have typically been well compensated over the long-term.