Bond-Fund Managers Take on More Risk

Pioneer Strategic Income ( PSRAX) began changing course late last year. After steering away from risky bonds, the fund started buying the kind of junk issues that were clobbered as the credit crisis unfolded.

"We bought a lot of high-yield bonds at the end of 2008 because they were getting cheaper and cheaper," fund manager Kenneth Taubes says.

Pioneer isn't alone these days. After taking shelter in Treasuries and other high-quality securities, some bond managers are beginning to take on more risk. The managers figure that with the economy stabilizing, it pays to buy corporates and other bonds that offer higher yields. Funds with strong long-term records that are taking more risk include Artio Total Return Bond ( BJBGX) and Osterweis Strategic Income ( OSTIX).

To be sure, not all funds are joining the charge into riskier corporate bonds. Most plain-vanilla bond funds stay broadly diversified and never place big bets on any one sector of the bond market. Such funds can make sensible long-term holdings. Because they stay diversified, their performance will never depart much from the averages.

But some investors may prefer more flexible funds -- including those that are moving into riskier issues. The flexible funds have the freedom to shift gears, emphasizing junk bonds one year and Treasuries the next. By changing holdings, some flexible funds managed to outperform the averages last year.

A solid flexible fund is Pioneer Strategic Income, which returned 0.7% during the 12 months ending June 26, outdoing 86% of competitors in the multisector bond category. The fund typically holds a mix of high-quality and junk issues. Beginning in 2007, Taubes started shifting to high-quality bonds. That reduced losses during the downturn of 2008.

Besides staying away from junk bonds, Taubes also avoided non-agency mortgages, which he had often held in the past. He correctly decided that mortgage markets would struggle because consumers had taken on too much debt.

Taubes became interested in junk bonds after they crashed last year. He says the market was pricing junk bonds as if there would be a 20% annual default rate. So far, the default rate has reached about 7%, and Pioneer has profited from the recent rebound in junk prices.

Another flexible choice is Artio Total Return Bond, which returned 0.5% in 2008, outdoing the average intermediate-term fund by 5.2 percentage points. Unlike many competitors that focus exclusively on U.S. markets, Artio is free to range around the globe, typically putting 20% of assets abroad. Last year a stake in Japan helped results. As investors sought safety, they looked to Tokyo. The yen rose, raising the value of Japanese bonds for U.S. investors.

Artio also avoided some damage last year by emphasizing high-quality issues, which weathered the storm. The fund held big stakes in Treasuries and had 71% of assets in securities that carried Standard & Poor's highest rating of AAA.

Lately, Artio portfolio managers Richard Pell and Donald Quigley have begun changing gears. Figuring that the economy is stabilizing, they have shifted away from the safety of low-yielding Treasuries and moved to corporate bonds. The fund now has no Treasuries and 45% of assets in corporate bonds. While 10-year Treasuries yield a skimpy 3.5%, it's possible to obtain yields of more than 6% from investment-grade corporate issues.

To make sure the corporate bonds can survive any market turmoil, Quigley says he's sticking with high-quality issues. "We want the kind of bonds that let you sleep at night," he says. "These are companies that have been through troubled times before and survived."

A favorite issuer is Comcast ( CMCSA), the cable-TV giant. Quigley says consumers may be shopping less these days, but they are reluctant to do without their cable service. Another favorite issue is from Johnson & Johnson ( JNJ). The health company has a strong balance sheet that should survive the recession.

While many funds take on more risk by buying bonds with lower credit qualities, Osterweis Strategic Income follows a different route. When manager Carl Kaufman becomes worried about unsettled bond markets, he buys short-term securities. Such debt rarely defaults, and it suffers only limited losses when interest rates rise. Short-term bonds typically pay meager yields. To boost results, Kaufman often buys short-term junk bonds, which have recently paid double-digit yields.

In 2008, Kaufman became extremely defensive, holding securities with maturities of one year or less. The strategy worked. The fund suffered only limited damage during the bond collapse of last year, returning 2.6% for the past 12 months and outdoing 95% of multisector bond funds.

Lately, Kaufman has turned more aggressive. He has been buying bonds with three-year maturities. "We have gone from being extremely defensive to taking on more risk," Kaufman says.

To manage default risk, Kaufman sticks with solid companies that have a lot of cash on their balance sheets and are generating free cash flow. A favorite holding is a bond from software maker Novell ( NOVL). The company has $1 billion in cash and only $121 million in debt. "I am not interested in distressed debt," Kaufman says. "I am interested in getting double-digit yields from high-quality issuers."
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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