The traditional safe harbor of fixed income in times of extreme market volatility doesn't mean your clients have to settle for today's low yields on Treasurys. Strategic income funds, often overlooked, offer diversity, reduced risk and the potential for higher returns. Unlike single-sector funds, strategic income funds invest in several sectors and permit the portfolio manager to change the mix as conditions warrant. The general theory behind these funds is that when one sector they invest in zigs the others may zag, thus potentially limiting investors' risk.

For financial advisors who need to allocate their clients' assets in the fixed-income firmament, these funds provide a flexible solution-broad exposure to multiple classes instead of one, including high-yield bonds, investment-grade corporate bonds, convertibles and leveraged loan products. Traditionally, to get broad exposure to the bond market, an investor would need to own several different classes of bond funds, such as a corporate bond fund, a total return fund or a short-term or long-term duration fund, but might miss out on other segments of the bond market.

Strategic income funds have their pros and cons, and not everyone is enamored of them. Their main benefits are flexibility and diversification, says Paul Herbert, a senior mutual fund analyst at fund tracker Morningstar Inc. "It's one-stop shopping. You can get exposure to different bond asset classes in one place. It can be helpful for an advisor or an investor who doesn't want to have to look and research bonds in many different sectors. You're not bound to a certain sector."

Chris Towle, lead portfolio manager of the Lord Abbett Bond Debenture Fund and investment manager of high-yield and convertible investments at the firm, says, "Their flexibility gives us so many more options. Multisector funds have interest-rate sensitivity in that the manager can vary the rate sensitivity along the [duration] curve. They also have credit sensitivity, which is a way of building returns just as valid as interest-rate sensitivity, and some even have a modest degree of equity sensitivity by including convertible securities."

Strategic income funds are not without risk, of course. "The risk is that you can get caught looking the wrong way if you decided to go heavily in a certain area and it hasn't worked out," says Herbert. "Hopefully, you're diversified enough and that hasn't worked too badly against you."

There's also manager risk, he says. "There's an extra skill set the manager must have in that he has to allocate assets across the board correctly."
"The weakness of these kinds of funds is simply the flip side of their advantage," says Paul R. Sanford, chief investment officer of Tow Financial Advisors in Sherman Oaks, Calif. "If the manager fails or underperforms, it can happen in a big way. Thus, multisector bond funds are, in their purest sense, a leveraged bet on the skill of the manager."

One example of a fund that took a wrong turn last year is T. Rowe Price Spectrum Income Fund, which tends to outperform the bond market in a strong economic environment and underperform in a weak economy. "For well over a year," says Ned Notzon, portfolio manager, "we underweighted high-yield bonds thinking their spreads were too tight and we also had a modest overweighting in stocks thinking the economy would have a soft landing. " But the economy turned out to be weaker than they expected so the fund's performance suffered.

Morningstar counts 157 funds in its multisector complex, including funds of all share classes. There are 55 distinct portfolios.
Far and away the biggest player is Loomis Sayles with two funds-the $16.2 billion Loomis Sayles Bond Fund and the $11.6 billion Strategic Income Fund. These are followed by the $9 billion Oppenheimer Strategic Income Fund and the $7.3 billion Lord Abbett Bond Debenture Fund. Also in this grouping are the $5.2 billion Fidelity Strategic Income Fund and the $6.1 billion Fidelity Advisor Strategic Income Fund (a load version), and the $5.2 billion T. Rowe Price Spectrum Income Fund.
Diversifying Cuts Risk

Strategic income funds each have different baskets. Their major components are U.S. government bonds, U.S. corporate investment-grade bonds and high-yield bonds. Some hold a sprinkling of U.S. government agency bonds such as Ginnie Maes. Usually a cap or floor applies to sectors to reduce risk. Most come with heavy loads and are sold through the advisor channel.

Maximizing Return And Minimizing Volatility

The funds are multisector and that can mean multicountry as well. Many invest outside the U.S. in the sovereign bonds of developed countries as well as those of emerging market countries. Some started as high-yield bond funds in the 1970s. They began diversifying in the mid-to-late 1980s, with some adding leveraged loan products and convertibles to the mix. In the last 10 to 15 years, an increasing number have made use of derivatives and futures to offset risk and generate higher returns.