This interview with Dan Fuss, who has managed Loomis Bond Institutional to a 9.7% annual return since opening it 24 years ago, appeared in Forbes, May 25, 2015 issue.
Bondholders: Defensive Moves
What insanity has overtaken bond buyers? Vainly seeking safety in diversification, they gobble up international bond funds with dismal yields. They chase performance, not realizing that momentum works in reverse in fixed income. Desperate for yield, they sit still for rotten deals from junk bond issuers.
This is a disaster waiting to happen. Daniel Fuss, comanager of the Loomis Sayles Bond Fund, is ready for it. He’s got $4.8 billion of ultrashort bonds burning a hole in his pocket.
The fund is extraordinary in two ways. Since Fuss opened it 24 years ago, this mix of junk and high-quality bonds (with a sprinkling of convertibles) has delivered a 9.7% compound annual return. That means he turned a dollar into $9. The return is ahead of the return on either a pure junk or a pure quality index and two points a year ahead of a 50-50 blend.
The other noteworthy aspect of the fund is how far it veers out of the baseline. Most bond managers choose to (and, in the case of index funds, have to) stay close to the market composite. Fuss and a changing cast of comanagers (currently Matthew Eagan and Elaine Stokes) aren’t afraid to stick out, at the moment with an extremely defensive posture. That is costing their investors money in the short term.
The fund’s 20% near-cash position earns nothing. Another 36% is in bonds due in five years or less, and those bonds earn next to nothing. Result: Over the past year the $24 billion fund has eked out a return of 1.8%, three points behind the Barclays U.S. Aggregate Bond Index (tracked by iShares Core U.S. Aggregate Bond, AGG). Fuss has seen plenty of bad weather during his 57 years in the credit business. But “I’m basically an optimist,” he says, recalling the portfolio’s 18-year average maturity in its early days. For this optimist the fund’s recent 6.6-year maturity represents a dramatic shift from risk-taking to preserving capital. (That capital belongs primarily to institutions. In 1996 Loomis opened the fund to retail buyers, at an expense ratio of 0.9%; among the latter are a lot of Fuss’ relatives, including a teenage great-grandson.)
Around the globe savers are nonchalantly absorbing debt issues that look absurd to people old enough to remember what a bond bear market looks like. Mexico just floated a security due in 2115 and paying 4% in euros. “A country issuing a 100-year bond in another country’s currency?” Fuss asks. “History has been unkind to that kind of transaction.”
Then there is the avid buying of developed-market government bonds, despite low (in some cases negative) yields. Investors have plunked $36 billion into the Vanguard Total International Bond Index Fund (BNDX for the ETF) which has three-fourths of its assets in Japan and Europe. They may have persuaded themselves that this kind of diversification gives them shelter from a bond crash. Or worse, they may think that the hot performance (total return over the past year: 7.5%) will go on.
Momentum in bonds? Banish the thought, says Fuss. When bond prices go up, yields go down. That doesn’t raise your expected return, it lowers it. The Vanguard fund yields 0.8%. This pathetic number, not the past performance, is the best gauge of future returns.
In the U.S. market irrational exuberance is most visible in junk. Junk bonds can be rewarding during economic expansions. But even in the best of times they are tricky because a corporate borrower usually reserves the right to call in a bond early. It will do that if its business improves and it can refinance at a lower rate. For the investor it’s a lopsided proposition. Tails you lose (in a default), heads they call the whole thing off.
Add to call risk another problem that has crept into junk of late: Exploiting the public’s thirst for yield, corporations are issuing bonds with covenants that allow more debt to be added atop the junk issue and/or give the borrower free operating rein as it slides into insolvency. Banks lending to corporations do not put up with such terms, Fuss says. They keep weak borrowers on a short leash.
Fuss says he learned a lot in his first job out of the Navy in 1958, working for Arthur B. Kohasky at the Wauwatosa State Bank in Wisconsin. Kohasky ran the bank for three decades and, well into his 90s, would haunt the loan department looking for signs of sloppy underwriting. He made it his business not just to know his corporate customers but to help them make a sale if that was necessary to collect on a loan.
Fuss takes risks on borrowers, but only after nitpicking analysis of the sort that would have made Kohasky happy. It helps that Loomis, Sayles (a Natixis subsidiary of which Fuss is vice chairman) has 49 credit analysts on staff. They had Fuss buying bonds from Ford Motor (F) when the market assumed that Ford would join General Motors in bankruptcy court. He got Irish bonds at fat yields during the meltdown. Not every such speculation works out. Fuss admits to acquiring, before the financial crisis, some of the doomed preferreds from Fannie Mae.
He’s adding few junk credits to the collection now. “Are you getting paid fairly for the risk? Absolutely not. Credit standards have weakened,” he says. This would not be a good time to be adding to your positions in junk funds (like SPDR Barclays High Yield, JNK, and iShares iBoxx $ High Yield Corporate, HYG).
After stints in money management and financial research, Fuss joined Loomis as a portfolio manager in 1976. It was in the middle of the worst decade ever for bonds. Fuss saw a bottom too early, acquiring long bonds for clients in 1979. But he still had some buying power two years later when the U.S. Treasury slapped a 15 3/4% coupon on bonds going to auction.
That auction, in September 1981, represented a historic turning point in interest rates. This year, as the yield on 20-year Treasurys dipped to 2%, there may have been an epochal turn in the other direction.
At 81 Fuss has 20 years to go to surpass his Wauwatosa idol in longevity. He’s patient. So what if cash yields nothing? “You grit your teeth and have lower income for a while,” he says.
Addendum: Until 2012, Dan Fuss and Kathleen Gaffney were the managers of this fund and Elaine Stokes and Matthew Eagan associate managers; since then, the managers have been Fuss, Stokes and Eagan.