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It's not easy holding bonds these days.

Rising interest rates, a sliding dollar, a yawning trade deficit and growing fears of inflation are gnawing at bondholders. In fact, many investors have been unloading their fixed-income investments ahead of what they see as a perfect storm on the horizon.

Not everybody is panicking, however. Investors who stuck with the


Loomis Sayles Bond fund, for example, earned more than 10% for 2004, beating the returns in many stock funds. The fund's co-managers, Daniel Fuss and Kathleen Gaffney, spent the year clipping high-yield bond coupons and heading north to buy Canadian bonds, taking advantage of dollar weakness.


recently spoke with Kathleen Gaffney to get her views on whether it's worth sticking with bonds in 2005.

There is a growing feeling among individual investors that they need to unload their bonds before rates rise. Is this justified?

I sense that people are thinking back to their most recent experience with rising rates, which was in 1994. That was when the


was moving very quickly and we had a very strong economy. This time we think the Fed will continue to raise rates, but take a wait-and-see attitude. That means we are not going to move a whole lot higher that quickly, so the principal loss on bonds should be relatively small.

Overall, the ability for people to count on the stability of current income is very attractive at this point. I would be more concerned about the effect of lower profits on equities due to the pricing pressure out there than a drop in bond prices due to a run-up in rates.

What is your opinion of the Fed's measured rate-hike policy? Are they getting it right?

I think the Fed is doing a very good job. They are keeping a watchful eye on inflation, Treasury market levels and what's happening overseas. They are getting it right.

What is your view on the strength of the economy?

The economy is moving in fits and starts, which is not indicative of real strength. You have some job creation, strong balance sheets and some business spending. But there still is the sense that businesses are somewhat cautious and the prospect of higher rates will slow down the consumer.

How is the consumer holding up? People keep writing off the American consumer as being tapped out, but he keeps coming back for more.

Given the overall level of interest rates, much of that fear is overdone. However, there are certain pockets of the consumer base, particularly in the lower to middle income range, where just a gradual change in interest rates could eat significantly into their discretionary spending and do some damage.

Aside from energy, inflation does not seem to be much of a problem. So it's hard to make the case for a rapid rise in rates due to inflation.

Exactly. And we don't think that is likely to change as long as the global economy works to its capacity. You have tremendous demand for key commodities in Asia that don't affect day-to-day spending in the U.S. The bulk of the goods that U.S. consumers spend their dollars on are still facing deflationary rather than inflationary pressures. Overall, I would say that we are seeing inflation in some areas and deflation in others and the result is a fairly balanced situation.

But those low-priced goods coming in from Asia, China especially, are creating a big trade deficit which, in turn, is causing the dollar to slide. The doomsday scenario is that our Asian creditors tire of seeing our currency weaken and start dumping their huge Treasury positions.

I think we have been fortunate that there is demand for our Treasuries, given the shape of the U.S. balance sheet. Given our deficit, interest rates should be a lot higher. We are really scratching each other's backs at this point. Low interest rates help the U.S. keep growing so we can absorb Asian goods.

In Asia, there has not been enough reform in their banking system, so they can't redeploy the savings that are growing there. That is not likely to change until the Chinese economy grows to the point where consumption starts driving their economy. So I think the fear of a drop in demand for our Treasuries, at least in 2005, is not realistic.

OK. Doomsday averted. Let's bring it back home. Your fund holds a lot of high-yield corporate bonds. What is the bond market saying about the health of corporate America?

It's pronouncing it very healthy. The overshoot from 2002 and all the corporate scandals really changed the mindset of CEOs across America. They became very focused on the balance sheet and on holding cash. So as long as the economy continues to grow, the fundamentals are positive toward corporates. There is a large amount of cash on the balance sheets, which is basically favorable to bonds.

But wouldn't it be better for the economy if the companies used some of that cash to build new plants instead of hoarding cash or even paying dividends?

That's the missing link. In a normal recovery, business spending would be kicking in by now and we are not seeing that. It is positive that the potential is there, but at some point those companies have to start reinvesting in themselves. But on the other hand, that excess cash is a positive for fixed income, which is beneficial to our fund's shareholders.

TIPS, Treasury inflation protected securities, were more popular than iPods this year, but you don't hold any in your portfolio. Why not?

TIPS grew in stature as the market grew nervous about the inflationary effects of a much stronger economy. At certain points in time, they did look interesting, but we are long-term investors, and we think TIPS are better buys when the economy is slowing and inflation fears subside. Right now there is not enough yield in TIPS, so they are not attractive to us.

One area where you have more than your fair share is foreign debt, especially Canadian bonds. What's going on up in the Great White North that is so attractive?

We are moving out of U.S. bonds because we think interest rates here have bottomed out and are likely to move up. One of the ways the U.S. is going to try and break through its current malaise is through a weaker dollar. Having said that, Canada appeared attractive to us for a couple of reasons: First because they had higher yields than the U.S. in the two-to-five-year range. That enabled us to shorten our portfolio and pick up yield. Second, the Canadian economy is heavily influenced by Chinese demand for natural resources and that benefits Canada's currency. And finally, from a pure credit standpoint, they have a current account surplus, which puts them in a much better shape than the U.S. That's a positive for the Canadian currency and we don't hedge currencies in our portfolio.

Your fund veers toward high-yield corporate bonds. In 2002 the high-yield market was spectacular, and last year it was rather muted. What is your view for 2005?

We still think high-yield is probably one of the best sectors for fixed-income, due to the positive fundamentals and, by definition, the higher yield. We have a low interest rate environment with moderate growth; that means clipping coupons and earning that extra yield is a great way to outperform.

Is there a particular issue that you like?

We think the higher quality of the U.S. corporate market is overvalued here. The opportunities we see are in BBB or below. We like the fallen angels from 2002 --









. These names we now would categorize as rising citizens, which means they are likely to go from below investment grade back to investment grade.