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Bond Skippers Say Worst of Credit Crunch Behind Us

Issue selection, inflation concerns still critical, panelists say.

Miriam Sjoblom, 07/01/2008

In an article previewing our bond-fund manager panel at the 2008 Morningstar Investment Conference, my colleague Paul Herbert posed several key questions for three of our favorite multisector bond-fund managers, and we were eager to hear their insights. Judging by the standing-room-only crowd at Thursday's session, we weren't the only ones looking for answers. Before a jam-packed audience, managers Dan Fuss of Loomis Sayles, Curtis Mewbourne of PIMCO, and Derek Young of Fidelity offered their views on the credit crisis, what keeps them up at night, and where they're finding the best opportunities around the globe in their wide-roaming strategies.

Given all the uncertainty that has plagued bond markets this past year, we find it comforting that these three managers have more to agree than disagree about--a sign that some clarity has returned to what, for many, has been a frustratingly fuzzy climate. Although some subtle differences emerge when they get down to the nitty-gritty details, we think the common themes that materialized in their discussion offer valuable insights into the opportunities and pitfalls present in bond markets today.

The Credit Crisis
You can breathe a sigh of relief, the panelists agree, because the worst of the credit crunch is behind us. Young kicked off the panel discussion by pointing out that the crisis, in its early stages, was fueled by widespread panic that souring subprime-backed securities would wreak havoc in unexpected places. On top of that, the complexity and obscurity of the securities in question made it difficult initially to get a handle on the overall size and scope of the danger. But as the crisis has played out, we've seen major financial institutions announce a series of subprime-related write-downs, giving investors a better handle on both the location and magnitude of the damage.

Mewbourne also cites the Fed's history-making measures in March--namely, taking on the role of lender of last resort to investment banks and orchestrating the Bear Stearns bailout--as a clear line drawn in the sand affirming the long-term viability of key U.S. financial institutions. Although the road ahead could be bumpy, both Mewbourne and Fuss think the slammed financial sector has opened up opportunities to buy solid quality bonds at extremely attractive prices.

Not So Fast
Even if the worst of the credit crunch is in the rearview mirror, not everything's coming up roses for this trio. All three point out that, as the impact of the credit crisis shifts from Wall Street to Main Street, USA, specific issue selection and careful fundamental research become even more critical. After all, some companies aren't equipped to weather tough economic times, and a bond-fund manager's success can hinge on avoiding the losers as much as--if not more than--picking the winners.

As a result, the group is collectively cautious about non-investment-grade corporate bonds. For starters, although prices on lower-quality bonds have taken a hit over the past year, they still don't look terribly cheap by historical measures. All three are holding below-average stakes in their respective funds, and Fuss in particular holds less than 10% in lower-quality corporates in Loomis Sayles Bond LSBRX. He does, however, think that certain CCC rated names have the wherewithal to not only muddle through, but actually improve their credit profile despite the broader economy's struggles. Although he argues that those companies are few and far between, he says there's money to be made for those with the skills to identify them early in the game. We'd definitely include his team in that camp.

The Next Wall of Worry
Should we be worried about inflation? Once again, three heads nod in unison. Buying Treasury Inflation-Protected Securities may seem like an intuitive way to combat the deleterious effects of inflation, but this group unanimously begs to differ. TIPS have enjoyed a splendid rally over the past year, and as a result, the low yields they currently offer just don't look compelling to this crew next to other options. As Young reminds us, TIPS are also highly sensitive to rising interest rates, and they've already started to feel some pain as Treasury rates have notched up recently.

Of course, the best way to beat inflation is to out-return it. Sounds easy enough, right? If that were the case, there might be more agreement among these managers about how to accomplish that goal. But while they're all somewhat optimistic it can be done, they deviate from one another in the details. Young, for instance, currently finds the sovereign debt of the G7 nations (excluding the U.S.) compelling, since he thinks the European Central Bank is doggedly committed to fighting inflation, and these bonds could benefit from a price pop if the ECB backs up that intent with meaningful policy action. By contrast, he's slightly underweight emerging-markets bonds in his charge, Fidelity Strategic Income FSICX, since he's concerned that their current prices don't leave much margin for error.

Mewbourne falls at the other end of the spectrum. He sees the best opportunities in developing markets, specifically corporate debt from firms that PIMCO has dubbed "global market champions," meaning large, fast-growing companies based in the developing world that have become formidable players on the global stage. Brazilian iron ore giant Vale RIO, which has garnered plenty of attention from stock investors while flying under the fixed-income radar, is a prime example of the type of debt he owns in PIMCO Diversified Income PDIIX.

For his part, Fuss occupies the middle ground between these two. Unlike Young, he's not confident the ECB will make smart policy choices. And although he agrees with the PIMCO team that changing economic dynamics worldwide make it increasingly important to scour the globe for opportunities, he admits that he's concerned about the quality of information available to bond investors looking to stake claims in companies based in developing markets. As investors gain a better grasp of the risks of these fledgling firms, he argues that it's important to stay broadly diversified.

It remains to be seen how these individual bets will pan out, but we wouldn't be alarmed by these differing viewpoints. When it comes to bond investing, there's often more than one avenue to achieving the same end. One thing is clear, though: Investing abroad has helped keep many bond funds out of hot water over the past year, and these managers, backed by deep, resourceful teams, think that story's far from over. But as PIMCO's Mohamed El-Erian pointed out in the conference's opening keynote address, the shifting global economic picture comes with new risks that create the potential for bumps in the road. Or as Fuss puts it--while the current setting comes packed with opportunities--a little patience is required.

Miriam Sjoblom is an analyst at Morningstar.

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