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By Jason Stipp | 04-12-2013 10:00 AM

Fuss: Time for Caution and Selectivity in Bonds

Relative to history and expectations, bonds are overpriced in general, says Loomis Sayles Bond manager Dan Fuss, who is taking a selective approach with caution toward credit risk.

Jason Stipp: I'm Jason Stipp for Morningstar. We're talking about the future of fixed income this week on Morningstar.com, and we're checking in with bond veteran Dan Fuss of Loomis Sayles Bond, that's a Gold-rated Morningstar Analyst-Rated fund. And he's going to tell us a little bit about his take on the fixed-income market today.

Dan, thanks for calling in.

Dan Fuss: You bet. Good to be here. Thank you.

Stipp: First question for you. Bonds were off to a somewhat tepid start overall in the first quarter of 2013, but we did see investors continue to put some money to work in bonds. And, of course, the flows into fixed income in recent times have been tremendous. So my question to you is, at this juncture what is a good reason, what is a bad reason, for someone to put money to work in fixed income today?

Fuss: Well, I'd like to say, there's never a bad reason, but the reality is that interest rates are very, very, very low, and I don't know the future anymore than anybody else. The odds, I think, highly favor a rise in interest rates going forward whenever the Fed stops buying Treasuries or slows it down. So that doesn't mean you avoid bonds. It does mean, however, that you have to focus on an approach to bonds that can deal with a rising interest rate environment. And that's very, very different from what the focus is when you have a declining interest rate environment.

Stipp: And, of course, a declining interest rate environment is something that investors have gotten used to, I think, over the recent past, as well as several years into the past. What about investors' expectations for their bond holdings? We've heard some folks talk as extreme as that we're in a bond bubble, which could be very painful for investors. You said there's not necessarily a reason to avoid fixed income altogether. But what should investors be expecting out of their fixed-income holdings, if, as you say, we're going to at some point see that rising rate environment?

Fuss: Well, what happens is, you have a bad news/good news [situation]. The bad news is interest rates go up, bond prices go down, depending on how far in the future you get your final payment--in other words, the average maturity of the fund if you're using a fund, or the absolute maturity for an individual bond.

The good news part of it is to the degree you're re-investing the coupon flow, for example, your income also rises. I grew up in the business for 23 years when interest rates always went up. It's a very different way of managing a bond portfolio. From a total return viewpoint, the total return lags the rise in rates. The income gradually goes up with a lag also with the rates.

So you have to be very careful not to be out, say, buying extremely long pure market risk, long Treasuries or Treasuries zeros, which works wonderfully well when rates go down. On the other hand, you can't come in and sit in Treasury bills, because you have no income. So you're somewhere in between. And if you're in munis, you ride the yield curve, doesn't work so well in taxables, and just pay attention to the bond portfolio. It's actually not a high turnover environment. It's bond-picking instead of taking market risk is a simple way to look at it.

Stipp: … When we hear commentators say things like "bond bubble," we expect that there'll be a period of sharp pain, where we will see potentially somewhat sizable losses in fixed-income funds. Is that a possibility that investors should be prepared for, for their fixed-income investments?

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