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Fund Focus

By Neil J. George on March 7, 2008

Not many months ago, it seemed that bonds were exactly the wrong thing to own. And even worse, our easy-to-own, packaged closed-end bond funds were getting pounded even as their underlying portfolios were hanging in there.

That was last summer, a time that seems, amid the continuing winter chill, as remote as its pleasant weather.

Bonds are now the new focus for investors and traders. More and more folks, turning away from stocks, are heading for quality. And this means bonds, but not just any bonds- government and upper-tier corporate paper.

Want proof? Take a look at the graph below, which shows the performance of intermediate-duration US government bonds and quality corporate bonds for the past year. 

Source: Bloomberg

The results are anything but fixed; we have gains and income amounting to more than 12.5 percent for US government bonds and 8 percent-plus for corporate bonds.

It’s not just about racking up the regular interest payments. Much of the gains have come since the start of 2008, with buyers lifting the offers nearly everyday so far in 2008.

This has happened almost in defiance of conventional wisdom, which says sell bonds when the US Federal Reserve Bank targets rates lower. The chatter over headline inflation, fueled by energy and food prices, is all about how high can it go and for how long. That’s not a typical setup for a bond breakout.

But what’s driving bonds isn’t the fear over how high headline inflation will go, but rather how low the US stock market and economy can sink.

Yet we can’t just buy any bond. Instead, we need to be picky. We need to focus on bonds that aren’t just immune from credit-market woes, but are also beyond the perception that credit risk will affect them.

Right Way or the Highway

Just as the markets have been shifting appreciation of risk, we needed to focus our attention on which bonds will continue to perform and which are really better off sold.

In the last issue, we sold a collection of individual bonds that had either run their course or weren’t giving us enough return prospects in light of mounting risks in the market.

Now we need to do the same for our collection of closed-end bond funds in the Portfolio.

We’ve applied similar risk/reward measurements, resulting in more calls to sell as we continue to refocus on funds that are performing well now and have greater prospects for working without getting whacked for the next several months.

The key is to look at the holdings and management of the underlying portfolios so we understand how the assets have performed and how the market perceives them going forward. Even if a fund’s portfolio is doing well, we need to make sure the stock market won’t hit us just because the fund is perceived as risky.

Last month, we sent the bulk of the floating-rate corporate loan funds packing. It’s not enough now to expect the rest of the market to take the time to go through portfolios; they keep selling or shorting them, assuming the worst rather than assessing the reality of their investments.

And now we need to do some final pruning.

BlackRock Diversified Income Strategies Portfolio (NYSE: DVF) isn’t as diversified as its title suggests when it comes to evaluating what will work in the current environment. Still loaded up with floating-rate bonds–which aren’t all bad but are perceived to be of higher risk–the fund is running lower.

“Hit the highway” is what we’re telling management. Sell BlackRock Diversified Income Strategies Portfolio.

DWS Multi-Market Income Fund (NYSE: KMM) has been a solid fund for years–until the past several months. With a lower yield and some questionable strategies, the fund doesn’t hold what we’d own on our own.

Although it’s down and trading at a discount, we need to focus on what’s working now and is likely to continue working. Sell DWS Multi-Market Income Fund.

LMP Corporate Loan Fund (NYSE: TLI) is one of the remaining floating-rate loan funds among our collection. We kept it longer because of management’s positive steps to pick up the best of this market segment.

However, with perception risk overwhelming the realities of the credit markets, we can’t stick with it. Sell LMP Corporate Loan Fund.

Watch and Wait

Moving beyond the sells, we hold other funds that have the right assets as well as the right management approach. But the market is sending share prices down.

We’re putting a number of funds on watch while we dig deeper into their prospects for not just better portfolio performance but better recognition by the market of their potential.

40/86 Strategic Income Fund (NYSE: CFD) has a solid assortment of good-quality bonds that pay well. But the market has either ignored it or seen it as something it’s not.

We don’t advise selling, nor do we advise buying more. 40/86 Strategic Income Fund is on watch; we’ll update you in coming weeks on our final call.

DWS Global High Income Fund (NYSE: LBF) is on watch because it’s been lagging the performance of its component bonds. Trading at a hefty discount of more than 12 percent, the lag in the stock versus the portfolio is concerning.

Our sense is that paying us well from quality bonds should be enough to warrant renewing our buy call. But for now, DWS Global High Income Fund is on watch.

The same goes for Morgan Stanley Emerging Markets Fund (NYSE: MSD). Armed with plenty of solid government bonds, including many with improving credit and currency conditions, the fund has lagged others. Morgan Stanley Emerging Markets Fund is on watch pending our further poking around.

Rivus Bond Fund (NYSE: BDF) holds assets that should also be working better for fund investors. Rivus focuses on quality corporate bonds, which are behaving as they should, but the fund is lagging.

Rivus Bond Fund is a watch for now. We’ll see if it makes the cut in the weeks ahead.  

Focus and Buy

The funds that remain are performing for us right now, just as they have for years.

AllianceBernstein Global High Income Fund (NYSE: AWF) owns primarily government and government agency bonds. It also holds select, high-quality corporates from domestic and foreign issuers, which adds to our stability because we’re not locked in to the US and the US dollar. We have exposure to the best Europe, Asia and other locales offer.

The average duration (measurement of price against changes in yield) is a conservative-but-attractive 7.4 years. Its government issues are top-grade and its corporates are of mid- to upper-tier credit quality.

The fund generates a yield just shy of 8 percent and returned nearly 100 percent during the past five years. The return for the trailing year exceeds 7 percent, and it’s up 2 percent in 2008.

Trading at a discount of more than 6 percent to its meltdown value, AllianceBernstein Global High Income Fund is a buy under 16.

BlackRock Income Opportunity (NYSE: BNA) maintains its primary holdings in government and government agency bonds, issued inside the US and from prime markets in the Americas, Europe and Asia. In addition to its government bonds, it also holds quality corporate bonds, with the majority of those of investment-grade quality.

The fund has generated a return of nearly 39 percent for the past five years; it’s in positive territory for the trailing year and for 2008 as well. Trading at a discount to its assets of more than 8 percent and yielding more than 6 percent, BlackRock Income Opportunity is a buy under 12.

PIMCO Strategic Global Government (NYSE: RCS) is the gold standard of bond funds. More than 70 percent of its holdings full boast AAA/Aaa ratings, a fact that comes as no surprise given its government focus. Because of its low average duration of about four years, even if we get the direction of rates wrong we won’t get burned.

The return numbers are more modest relative to other members of our collection. But performance is more predictable. The return for the last five years is in the upper-20 percent range. Year-to-date, however, it’s up more than 10 percent. It’s the one to go to when the markets have issues. Paying a yield of 7.4 percent, PIMCO Strategic Global Government is a buy under 13.

Following Pimco are two government bond funds that focus their holdings primarily outside the US including the prime growth and economicly improving markets of heavy resource producers Brazil and Russia.

Templeton Emerging Markets Income Fund (NYSE: TEI) and Western Assets Emerging Markets Fund (NYSE: EFL) focus on prime growth markets with improving economies such as resource-rich Brazil and Russia. 

Templeton Emerging Markets has returned more than 70 percent over the past five years. The fund is up nearly 5 percent so far in 2008. It yields more than 7 percent and is trading at a discount of 6.5 percent.  

The average duration for portfolio holdings is comparable to PIMCO Strategic Global Government’s, and the average credit is investment-grade-plus. Government bonds comprise the majority of its holdings.

Western Assets Emerging Markets has similarly solid credentials; average duration is shorter at around one year, and the average maturity is just six years. The majority of its holdings are government bonds, too. We have the stability we need.

Along with its prime corporate holdings, the portfolio mix should ensure performance in line with its five-year return of about 56 percent. The fund yields a little less than 9 percent and trades at a discount of more than 10 percent.

Buy Templeton Emerging Markets Income Fund under 17 and Western Assets Emerging Markets under 15.

In addition to our closed-end funds, we also hold one open-end fund, Vanguard GNMA (VFIIX). Vanguard GNMA focuses on the US-government-insured part of the mortgage market and, as such, continues to prove nearly bulletproof. 

It doesn’t pay as much as our closed-end funds, but it’s still an attractive cash alternative at more than 5 percent. The fund is still on track in 2008. Continue to buy Vanguard GNMA at current market prices.

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