Loomis Sayles Core Plus Bond Fund: Navigating Dynamic Markets with Tactical Flexibility

The global economic cycle is a perpetual force influencing interest rates, credit availability and capital markets. For core plus managers who seek to generate total return by balancing liquidity and risk, these undulations pose a clear challenge.

In our view, navigating dynamic market cycles demands a flexible mandate and the ability to combine rigorous macroeconomic insight with security-specific fundamental research. The Loomis Sayles Core Plus Bond Fund is a Benchmark-aware product that seeks to add return in stable-to-improving risk markets and preserve principal during adverse markets using tactical portfolio allocations. When market conditions are constructive and risk/return measures warrant, the Fund typically pursues a yield advantage over the Barclays US Aggregate Bond Index through allocations to “plus sectors,” such as high yield credit and non-US dollar. During periods that call for more defensive positioning, the Fund generally adopts a higher-quality, more Benchmark-like posture. The challenge lies in determining where to deploy capital at any given time. As such, our investment process begins with a top-down assessment of the global macroeconomic environment and capital market drivers—a view that we use to determine sector, security, yield curve and duration positions within the core portion of the Portfolio as well as exposure to the plus sectors.

With this nimble approach, the Loomis Sayles Core Plus Bond Fund has achieved strong returns through a range of economic and market environments, as shown in the chart below.

LOOMIS SAYLES CORE PLUS BOND FUND CLASS Y SHARES
AVERAGE ANNUAL TOTAL RETURNS AS OF 9/30/2014

Performance data shown represents past performance and is no guarantee of future results. Investment return and value will vary and you may have a gain or loss when shares are sold. Current performance may be lower or higher than quoted. For most recent month-end performance, visit www.loomissayles.com.

Performance for other share classes will be greater or less than shown based on differences in fees and sales charges. Performance for periods greater than one year is annualized. Returns reflect changes in share price and reinvestment of dividends and capital gains, if any. You may not invest directly in an index.

Gross expense ratio 0.54% (Class Y). Net expense ratio 0.54%. As of the most recent prospectus, the investment advisor has contractually agreed to waive fees and/or reimburse expenses once the expense cap of the fund has been exceeded. This arrangement is set to expire on 1/31/2015. When an expense cap has not been exceeded, the fund may have similar expense ratios and/or yields. Class Y shares are available to certain institutional investors only; minimum initial investment of $100,000.

The Class Y inception date is 12/30/1994. Class Y shares are sold to eligible investors without a sales charge; other Classes are available for purchase.

The Importance of a Macro View

To confidently position the Portfolio, we must first understand the macroeconomic themes shaping the investment landscape. Drawing on Loomis Sayles’ deep macroeconomic and sovereign research capabilities, we continuously assess key global macro factors (GDP growth, monetary and fiscal policy, inflation, supply/demand dynamics of government bond markets, credit availability and politics), which are typically driven by the world’s major developed economies. As the graphic at right illustrates, our view of the overall global economic cycle helps us determine a balance between the goals of return maximization and capital preservation and, accordingly, how to position the Portfolio relative to the Benchmark (up or down in quality, liquidity and price transparency).

While one or two major economies tend to lead the global economic cycle, individual economies do not progress through the cycle in lockstep. Our ability to identify “mini cycles” and assess credit conditions in individual economies is critical. We rely on insights from our sovereign research team, whose knowledge of local markets helps us pinpoint where opportunities and risks may exist.

Tactical Sector Allocation

Once our macro and sovereign research groups have identified economic cycle themes, tactical use of sectors—including out-of-Benchmark exposure—allows us to target opportunities using what we believe are the right instruments. The Fund has the flexibility to invest up to 20% in high yield (including bank loans) and up 10% in non-US-dollar investments (including currencies and emerging markets debt).

When making sector allocations, we are mindful of a cycle’s idiosyncrasies: the best strategy for one period of credit repair, for example, may not be optimal during the next phase of credit repair. To make informed decisions, we draw on our own experience and firm resources, including specialized sector teams (asset class strategy groups comprised of portfolio managers, traders and research analysts). We then implement our sector strategy through fundamental bottom-up security selection. In partnership with Loomis Sayles’ credit, sovereign and securitized research analysts, we identify what we think are the best securities and appropriate position sizes based on issuer volatility, relative valuation and liquidity. The chart to the left illustrates the Loomis Sayles Core Plus Bond Fund’s tactical use of sectors during the ten years ended December 31, 2013. To help enhance total return potential and minimize risk, the Fund is generally positioned similar to the Barclays US Aggregate Bond Index during economic expansions and downturns, while credit and non-dollar exposure is added during periods of repair and recovery. Historically, more than 50% of the Fund’s return has come from sector allocation.ⁱ

Plus Sectors: The Tool Kit

Though these sectors are often thought of as increased risk/reward areas, we think plus sectors can help reduce portfolio risk. Overly constrained mandates can force managers to take less attractive positions because of limited flexibility, thereby introducing unintended risk into a portfolio. Plus sectors allow us to scour a broader opportunity set when seeking what we view as the best investment options for the Fund. However, because these sectors can introduce tracking error, we require a higher potential return per unit of risk before we will invest out of Benchmark. Allocations to plus sectors, detailed in the chart at left, have contributed approximately 40% of the Fund’s total return over a market cycle.ⁱⁱ

Source: Loomis Sayles. Data as of 12/31/13.
Due to active management, characteristics will evolve over time.

We employ plus sectors to construct pro-cyclical, offensive portfolio positions and to help defend against specific market risks, as described in the following case studies.

• High Yield Corporate Bonds & Bank Loans: High yield can be attractive during periods of the economic cycle that we characterize as repair, recovery and expansion. It generally offers a yield advantage over many other fixed income sectors and can benefit from capital appreciation when credit spreads tighten. Because high yield bonds generally have a yield cushion, they can exhibit reduced duration sensitivity and may serve as a defensive hedge against rising rates. High yield bonds are lower in the capital structure than bank loans, and their increased credit and liquidity risk make them high-beta assets. Bank loans hold a senior position in the capital structure, and while this can limit their upside potential during recoveries, it is a valuable defensive credit feature in later-stage economic expansions. Bank loans’ floating rate coupons can be beneficial when rates rise.

HIGH YIELD & BANK LOAN CASE STUDY: 2009-2013

	2009: Credit Repair/Recovery	2010-2011: Recovery	2012-2013: Late-Stage Recovery
Strategy Themes	Maximize market exposure and favor more defensive industries.	Emphasize specific risk and credit sensitive industries that are typical late cycle recovery stories.	Seek to mitigate interest rate risk while still maximizing portfolio yield. Focus on late-cycle credits and industries.
Strategy Implementation	Emphasized long duration, lower-quality HY. Focused on companies with stable, liquid balance sheets and sectors that appeared well positioned to benefit from recovery as part of strategy to maximize duration contribution, price appreciation potential and yield.	Began moving up in quality. Used higher quality HY issues with intermediate and shorter durations to help capture incremental yield while reducing exposure to credit and duration risk.	Increased bank loan allocation. Sought floating coupon as part of strategy seeking to maximize yield while minimizing duration in anticipation of higher Treasury yields.

• Non-US Investments: Today, roughly 80% of global GDP comes from outside the US.ⁱⁱⁱ Our guidelines allow us to follow economic growth opportunities around the world and to take targeted exposure outside US fixed income markets. When the risk/return prospects appear particularly compelling, we deploy non-US investments offensively to emphasize directional themes within the global economic cycle. We can also use the allocation defensively to offset or hedge against other risk exposures in the Portfolio. The Loomis Sayles Core Plus Bond Fund is able to invest directly in global currencies, non-dollar corporate or sovereign bonds, or dollar-denominated bonds of non-US issuers (Yankee bonds).

  • Currencies: Currencies can be utilized to express pro-cyclical or defensive views of global markets, to go up or down in quality and liquidity, and to take advantage of price dislocations or perceived overreactions in the market.

  • Non-dollar-denominated bonds & dollar-denominated bonds of non-US issuers: We can use these tools to invest in countries or companies whose balance sheets, bond yields, or bond market supply/demand dynamics appear attractive.

NON-US CASE STUDY: 2004-2013

	2004-2006: Expansion	2007-2008: Downturn	2009-2013: Recovery
Strategy Themes	Gradually move away from US and into markets still enjoying solid economic growth.	Assume a much more defensive posture in both US and non-US portfolio holdings.	Follow fiscal and monetary policy responses around the globe. Focus on early-recovery stories (US) and countries tied to cyclical recovery (Canada and parts of Latin America and Asia).
Strategy Implementation	Began in US-dollar denominated and pro-cyclical non-US-dollar investments (Australian and New Zealand dollars, Swedish krona). Defensively moved into the Norwegian krone, euro and Swiss franc as US economic fundamentals deteriorated.	Entered into long yen position as a partial hedge in anticipation of a risk-off period. Yen was fundamentally undervalued and had been used as a funding currency for carry trades. We felt yen could rally sharply if investors unwound the carry trade.	Sought currencies of growing economies tied to the global recovery (Mexican and Philippine pesos, Canadian and Australian dollars). In later 2012 and early 2013, believed European Central Bank support would be sufficient to help peripheral European bond yields (Spain, Italy and Portugal) compress toward those of core Europe.

Risk Management

When managing a Benchmark-aware strategy with the goals of preserving principal in adverse markets and adding excess return in stable-to-improving environments, risk control and downside protection are paramount. Relative and absolute risks are monitored continuously, and our ability to position similar to or away from the Benchmark is central to risk management efforts. While we do not manage to track error, we are very mindful of the Benchmark and add to tracking error only when we feel we are being compensated to do so. The Fund typically maintains a minimum 10% allocation to government-related securities, including Treasurys and agencies. This positioning helps deliver a source of liquidity and also provides a directional link to interest rate movements, which informs how we manage portfolio duration and yield curve exposure. In volatile environments, we typically favor high-quality liquid government securities. During periods of economic repair and recovery, credit and non-US-dollar exposure can be used to help shorten duration and hedge interest rate risk given their traditionally low correlation with US Treasurys and agency mortgage-backed securities.

Conclusion

Today’s ever-evolving economic cycles and complex global markets demand flexibility. Our Benchmark aware, research-intensive investment style combines macroeconomic insight, changing tactical allocations and security-specific expertise to meet this need. As a portfolio management team, we have managed through multiple global economic cycles and have experienced the dynamic behavior of bond duration, yield curves, currencies and sectors. Drawing on this experience and Loomis Sayles’ research arsenal, we seek to populate the Portfolio with what we believe are the best ideas for each unique market environment and deliver principal protection and solid risk-adjusted returns to our investors.

About Risk

Because the Fund can invest a significant percentage of assets in foreign securities, the value of the Fund shares can be adversely affected by changes in currency exchange rates, political, and economic developments, which can be significant in emerging markets. The Fund is subject to currency risk, the risk of fluctuations in exchange rates between the US dollar and foreign currencies, which may cause the value of a Fund’s investments to decline. Funds that invest in securities denominated in, or receive revenues in, foreign currency are subject to currency risk. Because the Fund can invest a significant percentage of assets in debt securities that are rated below investment grade the value of Fund shares can be adversely affected by changes in economic conditions or other circumstances. These events could reduce or eliminate the capacity of issuers of these securities to make principal and interest payments. Lower-rated debt securities have speculative characteristics because of the credit risk of their issuers and may be subject to greater price volatility than higher-rated investments. The secondary market for these securities may lack liquidity which may adversely affect the value of these securities and that of the Fund. The purchase of Fund shares should be viewed as a long-term investment. Mutual funds that invest in bonds can lose their value as interest rates rise and an investor can lose principal.

Endnotes

ⁱ Loomis Sayles attribution; data from 1/1/2003–12/31/2013.

ⁱⁱ Loomis Sayles attribution; data from 1/1/2009–12/31/2013. Market cycle defined as three- to five-year period.

ⁱⁱⁱ Bloomberg Pro; 2013 World Bank data.

Disclosure

Barclays US Aggregate Bond Index is an unmanaged index of investment grade bonds with one- to ten-year maturities issued by the US government, its agencies and US corporations. Indexes are unmanaged and do not incur fess. It is not possible to invest directly in an index.

This paper is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.

Past market experience is no guarantee of future results.

Before investing, consider the fund’s investment objectives, risks, charges, and expenses. Please visit www.loomissayles.com or call us at 800-225-5478 for a prospectus and a summary prospectus, if available, containing this and other information. Read it carefully.

This information is intended for institutional investor and investment professional use only. It is not for further distribution.

The original paper can be found here on the Loomis Sayles website.

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