Investing in Multi-Sector Bond Funds

Multi-Sector bond fund launches have reached record high levels in 2007, showing a doubling in the number of new funds since 2006. Record net inflows, consistently positive 10-year performance, and one-stop diversification benefits have made Multi-Sector bond funds increasingly attractive as an asset-gathering instrument. This article reviews the state of the Multi-Sector bond category in terms of characteristics:

• Net flows and performance
• Leading funds
• New fund launches
• Best practices

Category Overview

Multi-Sector bond funds were designed to provide one-stop shopping for fixed-income investors, emphasizing the benefits of income and diversification. These bond funds have several advantages over regular fixed-income funds, as they can invest across a broad spectrum of bond asset classes, take substantial amounts of credit risk by investing in junk and emerging markets debt, and often make aggressive bets on the overall bearing of interest rates.

Since riskier bonds are often underrepresented in an investor's portfolios, such market exposure can add to the portfolio's long-term potential and decrease volatility. The Multi-Sector category has a 3-year correlation of 0.54% to the S&P 500 index (as of August 2007), and 0.62% correlation to the Lehman Brothers Aggregate Bond Index for the same time period.

Most funds in this space include a total return component in their objectives. Along with income and capital appreciation potential, such a component could potentially minimize the need to liquidate a portion of the principal balance to meet current income needs. For baby boomers, this is an important advantage as increasing life expectancies could mean a retirement period that extends anywhere from 15 to 35 years.

Competition in the Multi-Sector category revolves around the leading fixed-income firms, including Loomis Sayles, Fidelity, Oppenheimer, and PIMCO. External to the fixed-income space, there is competition from target-date mutual funds. Fixed-income ETFs are also becoming a competitive factor.

Net Flows and Performance Net Flows

The Multi-Sector category is the second-best-selling bond category in 2007, on a year-to-date basis through August. Posting net inflows of $11 billion, the category trails only the Intermediate-Term category. In fact, the category has been on a tear ever since the end of the bear market in 2002 and has consistently posted net inflows (a total of $34 billion, which again is second only to the Intermediate-Term category). In terms of asset growth year-to-date, Multi-Sector bond assets grew at a 21% rate, which puts it among the top three fixed-income categories along with World Bond and Long-Term.Performance. The Multi-Sector bond category has some of the highest returns among fixed-income categories. Posting 6.4%, 6.7%, and 9.2% average returns for 1-, 3-, and 5-year periods, respectively, this category holds the second-best performance in the bond space after the Emerging Markets category. However, Emerging Market bond funds carry a higher standard deviation (risk) profile, and pricey expense ratios.Leading Funds

Best-Sellers

The category's leaders for the first eight months of 2007 come from the Natixis and Fidelity fund families: Loomis Sayles Bond with $4.4 billion, Loomis Sayles Strategic Income with $3.3 billion, and Fidelity Advisors Strategic Income with $0.89 billion. Trailing close behind are PIMCO Dividend Income with $0.82 billion and Oppenheimer Strategic Income with $0.78 billion.

Top-Performers

Natixis has a firm grip on this category, placing three of its funds on top, in addition to sub-advising another top performer, Maxim Loomis Sayles Bond. In terms of performance, Natixis holds the top honors with Loomis Sayles Fixed Income that posted 11.3%, 9.7%, and 14.4% returns for the 1-, 3-, and 5-year periods. Other notable funds with top-decile rankings for all measured time periods are Loomis Sayles Bond, Loomis Sayles Strategic Income, Oppenheimer Strategic Income, and Maxim Loomis Sayles Bond. New Fund Launches

Every year brings three to four new Multi-Sector bond funds. During 2006, there were three new funds, and in 2007 there were a record six new launches, indicating that consistently positive net inflows and performance will attract more competitors in the field.

RiverSource is among the latest entrants to launch such a fund, which has gathered $111 million in assets and has net inflows of $39 million through the first eight months of August. Other noteworthy 2007 entrants include Transamerica IDEX (sub-advised by Loomis Sayles), Hartford, and PIMCO. Best Practices in the Category The five top-performing Multi-Sector bond funds exhibit divergent characteristics compared to their peers:

• Equity-like annual returns (more than 13% for the 5-year period, vs. 9.1% for the average fund)
• Lower expense ratios (A-shares are 99 bps vs. 107 bps for the category)
• Portfolio managers have twice the length of tenure and currently keep nearly 98% of fund assets invested in U.S. assets, vs. 87% for the category
• Lower correlation to other markets and bond categories
• Benefited by avoiding the financial sector, keeping 6 % exposure to financials vs. 21% for the category

Despite the attractiveness of the category, Multi-Sector bond funds are not for all asset managers. Determining the portfolio construction process can be absolutely overwhelming when a number of factors must be addressed, such as global credit cycles, global yield curves, default rates, currency fluctuations, Fed/ECB policy, geopolitical concerns, and bond upgrades/downgrades.

The less restrictive guidelines under which Multi-Sector bond strategies are managed necessitate expertise across the entire global fixed-income spectrum. Best-of-breed managers in this space are known to cover every major bond market sector and have significant acumen in yield analysis. OutlookIn the short term, there will be weaker investor demand as a result of the sub-prime mortgage problems and the resulting credit crunch. In the long run, Multi-Sector bond funds should continue to provide more return potential than intermediate funds, but they could also be pressured by their more conservative governmental rivals. Expect advisors to increasingly recommend Multi-Sector bond funds in a dollar-cost-averaging strategy as a one-stop approach for fixed-income diversification. To satiate this demand, fund families will continue to roll out Multi-Sector bond funds, although it will be challenging to win assets and market share from the established asset managers in this space.