What Kathleen Gaffney is buying before rates spike

Popularity often comes with a big price in the mutual fund world. Right about the time most of us become aware of a fund's great performance and invest, its returns start to suffer. Academic studies show that a big influx of assets can make a fund less nimble and lead managers outside their ideal investment universe. It can also have a psychological effect on managers, who can become overly risk averse lest they make a mistake and lose all those assets. New funds, of course, have a different problem. They're untested so investors, often wisely, avoid them. The solution to this quandary: Find a new fund run by a very experienced manager. The Eaton Vance Bond Fund fits that bill (EVBAX). Launched this January, the fund had $157.1 million in assets as of May 31. Yet manager Kathleen Gaffney is no newbie, having co-managed the $20 billion Loomis Sayles Bond Fund (LSBRX) with Dan Fuss for 15 years. That fund nearly doubled the performance of its average peer during her co-manager tenure and beat the major bond indexes by a wide margin. It delivered a cumulative 241.5 percent return, or 8.5 percent annualized, according to Morningstar. Gaffney was at Loomis 28 years before joining Eaton Vance Corp. (EV) last October. A Small Advantage Gaffney plans to take full advantage of her new fund's size. “The flexibility and nimbleness of being small is a huge advantage in this market,” she says. Gaffney believes that we're heading into a rising rate environment where a number of bond sectors will get hurt. When that happens she will liquidate a portion of her current portfolio to buy bonds that have become more attractively priced in the downturn. “I could liquidate most of my positions right now in a matter of one day,” she says. “When I had $20 billion, it could take weeks to do that.” To play it safe, the fund manager holds 10 percent of her portfolio in short-term Canadian mortgage bonds, which are very liquid. She likes the Canadian dollar and the yields are slightly better than in the U.S. “The currency in Canada is leveraged to natural resources, particularly oil, and I think that's an additional positive as an inflation hedge,” she says. Gaffney is also finding value in niche sectors that larger funds would have trouble investing in effectively. She has only 70 key holdings, compared to the more than 400 she had at Loomis. Convertible bonds and preferred stocks in small companies like commercial real estate financier iStar Financial (SFI) and medical device maker NuVasive (NUVA) make up about 15 percent of the fund. Convertible bonds are considered hybrid securities because they pay interest like bonds but if the stock of their issuers rises above a certain level, the bonds can be converted into stock. That type of bond is a useful interest rate hedge, says Gaffney. While convertible bonds pay limited interest and a fixed principal back at maturity, the potential upside for stocks is unlimited. That has typically made them more resilient in inflationary rising-rate environments especially if the underlying stock is a good one. “We have a great deal of confidence in the underlying stocks of our convertible bonds,” she says. Too Popular Gaffney is also investing in floating-rate preferred stocks issued by student loan company SLM Corp. (SLM) -- formerly known as Sallie Mae -- as a substitute for floating-rate bank loans and junk bonds, which she says have become too popular. “It's become more of an issuer's market than an opportunity for investors to find great value,” she says. Sallie Mae's preferred stock trades at $69.50 a share, a deep discount to its $100 par value. The stock has a coupon payout of 1.7 percentage points above the London Interbank Offered Rate, or LIBOR, which is currently .7 percent. Gaffney suspects if interest rates rise, companies like Sallie Mae will redeem floating-rate preferreds to avoid the expense of increasing debt payments. Then the price of Sallie Mae's preferred shares would rise from $69.50 to its par value of $100 -- a gain of 45 percent. That would be on top of any interest payments. It's too soon to predict how this fund will perform long-term. It does have advantages over both more bloated and less seasoned peers. In the last three months, it has delivered a 4.8 percent return, beating 97 percent of the funds in its Morningstar Multisector Bond fund category and Loomis Sayles Bond's 2.9 percent. Although the Eaton Vance Bond Fund normally charges a 4.75 percent commission or load for buyers of its A share class, it can be purchased load-free at TD Ameritrade and Fidelity. Its .95 percent expense ratio is high for a bond fund, but comparable to Loomis Sayles' .92 percent. The expense ratio is likely to go down as the fund gains more assets. That's one of the few investor payoffs from popularity in the mutual fund world. --Bloomberg News--