April 3, 2007

MUTUAL FUNDS QUARTERLY REVIEW

This Manager's Folksy Manner
Belies His Record -- and Worries

By MICHAEL HUDSON and JOANNA SLATER
April 3, 2007; Page R1

To hear Dan Fuss talk, you might not think he has run one of the top bond funds in the world over the past decade. Ask for a prediction about the market, and he says: "This is obviously guesswork. The odds of this being correct are zero."

Or: "This guess is on very tenuous, very thin ice."

Or: "Does anybody call the economy well? I don't."

Or: "This is a bedtime story I'm telling you."

WALL STREET JOURNAL PODCAST

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Dan Fuss talks² with WSJ reporter Mike Hudson about the 10-year record at his multi-sector bond fund.

The folksy manner belies his fund's formidable record: The $10.6 billion Loomis Sayles Bond Fund, which Mr. Fuss has managed since its inception in 1991, has returned an average of 11% a year since then and is ranked as the No. 1 fund in its corporate-debt category over the past decade.

That makes Mr. Fuss, 73 years old, one of the best bond-fund managers in the business -- arguably better than higher-profile peer Bill Gross of Pacific Investment Management Co., who runs the biggest bond fund in the country. Mr. Gross's $102 billion fund, up an average 8% a year since its 1987 inception, is in a category that generally carries less risk.

Dan Fuss and Kathleen Gaffney hunt for bargains in odd places.

Mr. Fuss has prospered by looking for bargains in odd places -- from the debt of a troubled biotech company to General Electric Co. bonds payable in New Zealand dollars. He and his co-manager, Kathleen Gaffney, 45, like finding out-of-favor bonds "before the rest of the world notices," he says.

After nearly 50 years, he likes to joke that he's been around the markets so long that they feel like a favorite corner tavern. The only thing to worry a regular like him, he says, is "a change in the bartender."

Pricier Borrowing

It's definitely a time of change in the bond markets, Mr. Fuss believes. After 20 years of falling interest rates, he's ready to declare an end to the era of cheap borrowing. The U.S. government's need to fund its deficit will soon usher in a long period of rising interest rates, he thinks.

That economic outlook reminds him of a similar period in the late 1960s. Back then, federal spending on the Vietnam War and Great Society programs helped spark inflation that the government attempted to tackle by raising interest rates, a trend that generally held until the early 1980s. Mr. Fuss sees today's U.S. budget deficit expanding over the next 16 years. This time around, the increase will be driven by "spending for old folks," he says. "I'm very glad.... I'm an old folk and I'd like to see young folks support me."

THE JOURNAL REPORT

³ • Check the performance of top mutual funds in 19 sectors⁴, largest stock funds⁵ and bond funds⁶ and how fund categories stack up⁷.

• See the complete Mutual Funds Quarterly Review⁸.

Wisecracks aside, the outlook of a bond-fund manager who has profited from the turns of the economy over the past 15 years is worth serious attention. In recent months, many investors have oscillated between fear of a steeper-than-expected business slowdown in the U.S. to cautious optimism about the economy. The upbeat view has faltered in past weeks as turmoil hit world markets, but one constant has been the expectation that interest rates will remain relatively low.

If Mr. Fuss's long-term assessment is right, investors will have to switch gears again. Higher rates typically hurt stocks by raising borrowing costs for companies and consumers, further damping economic activity. He sees the yield on the 10-year Treasury remaining near its present level of just above 4.5% in the short term, before rising to as high as 6.5% over the next three years.

An environment of rising interest rates isn't necessarily bad news for bargain hunters like Mr. Fuss and Ms. Gaffney. In recent years, their bets have included indebted semiconductor companies, retailer Kmart Co. and currencies they believe will appreciate against the U.S. dollar. "We were active in Iceland a couple of weeks ago," he says.

Mr. Fuss is "a voice of reason in the mutual-fund arena," says Paul Herbert, a senior fund analyst at Morningstar Inc. "It's not just his investing acumen, but the sense that he's in it for the little guy." Mr. Herbert notes that Mr. Fuss has invested more than a million dollars of his own money in the flagship bond fund.

The Virtues of a Pencil

Mr. Fuss got into the bond business in 1958, after returning to Wisconsin following a tour as a lieutenant in the U.S. Navy. He began working at the local bank in Wauwatosa, where he had tucked away savings from his boyhood paper route. He did everything from mopping floors to running numbers on the bank's bond portfolio. He started working for Loomis Sayles in 1976.

Mr. Fuss still favors some of the work routines he learned back in the early days. He isn't averse to computers and Blackberrys -- he uses both -- but also likes to keep track of trades and markets on an old-fashioned 13-column paper ledger.

"I learn a lot through the end of a pencil," he says. "Every day I'm doing some pencil work. And also three-colored pen work." Each weekday, he writes down prices for specific bonds. On Fridays, he writes down commodity prices. On Saturdays, he records trends in the bond and stock markets.

He's even been known to use a slide rule to do calculations. "I do like the rule," he says, "because unlike the computer, you can scratch your back with it."

Ms. Gaffney joined Mr. Fuss as co-manager on the fund in 1997. Her early days at Loomis Sayles were spent trading stocks, and she used to poke her head in the "war room" where fund managers monitored the day's events. Usually she was the only woman in the room, and "Dan would always chat, no matter what," she recalls. Later he tapped her to join his team of bond traders.

The fund operates within certain constraints: 65% of its assets have to be in investment-grade debt, and no more than 20% can be bonds from outside the U.S. and Canada. Those limits aside, the managers roam widely both in terms of geography and the credit quality of their bonds.

"They're going places where others might not go to the same degree in emerging markets and high-yield bonds," Mr. Herbert says.

One good buying opportunity is investment-grade bonds that have been downgraded due to a leveraged buyout or a private-equity deal. Mr. Fuss says he loves getting "fallen angels" that are on the verge of climbing back into investment-grade category.

Another example of the duo's bond-picking strategy is their approach to biotech firm Vertex Pharmaceuticals Inc. In the mid-1990s, a promising drug in the company's pipeline didn't work out and the stock plummeted. Mr. Fuss and Ms. Gaffney held the company's convertible bonds, which are securities that can be converted into stock at a certain price.

The fund managers analyzed the company's finances and concluded it had enough cash to fund its operations for five to seven years, so they decided to stick with it. Finally, in 2005, Vertex announced promising initial results for an oral Hepatitis-C drug with huge potential. The stock jumped 20% in a single day in May. And from then until the end of that year, it gained an additional 106%.

Such bets don't always pan out, of course. Mr. Fuss and Ms. Gaffney bought Delta Air Lines Inc. bonds in 2000 because they thought the company had the strength to withstand an economic downturn. But then the attacks of Sept. 11, 2001, and the emergence of low-cost rivals combined to hobble the airline. Bonds purchased at 80 cents on the dollar fell to 20 cents on the dollar, at which point the managers cut their losses.

These days, Ms. Gaffney says, it's becoming more difficult to deliver returns in the developed world and places like Asia have captured their attention. "There are fewer pockets of value" in developed markets, she says. "It's getting trickier and trickier."

Every weekday morning at 9:15, Mr. Fuss gets a snapshot of how bonds are performing around the world as traders recap the previous day's action and talk about what's going on. On one morning in February, discussion swirled around HSBC Holdings PLC's announcement about the extent of bad loans in its mortgage business, the meeting of finance ministers from the Group of Seven developed countries, and a recent inflation figure from Mexico.

Mr. Fuss' interest in overseas markets stems partly from what may unfold at home. He expects federal spending will grow as a percentage of economic activity, and budget deficits will require the government to issue more debt. With a greater supply of Treasury bonds in the market, their prices will drop, pushing their yields higher.

He expects inflation to pick up even as economic growth decelerates. His term for it is slowflation, which would be an unappealing prospect but less severe than the stagflation seen in the 1970s, when the economy actually shrank even as prices rose.

He expects inflation to pick up even as economic growth decelerates. His term for it is "slowflation," which would be an unappealing prospect but still fall short of stagflation, the combination of a shrinking economy and rising prices witnessed in the 1970s.

Mr. Fuss says it's a good time to be cautious about higher-risk junk bonds. Investors might also consider tax-deductible municipal bonds as a way of protecting themselves against tax increases aimed at reining in a rising deficit.

For his fund, he says, an environment of rising interest rates "pushes you back toward item selection and patience."