For years, Kathleen Gaffney was, in effect, a lady-in-waiting - waiting for Dan Fuss, her longtime mentor and co-manager at the Boston-based Loomis Sayles Bond Fund (LSBRX), to retire.

But although Fuss, a bond luminary, is now 80, he isn't going anywhere.

So after more than two decades working at Fuss' side, Gaffney moved on. Her new home is just a few blocks away at Eaton Vance, where she serves as co-director of investment-grade fixed income. The new Eaton Vance Bond Fund (EVBAX) was launched this past January to put her considerable talents in the fixed-income market to work.

Launching a bond fund at the very end of a three-decades-long bull market in bonds isn't exactly optimal timing for a value manager. Bonds had become so expensive that in May the yield of the 10-year Treasury note sank to 1.66%. But then Fed Chairman Ben Bernanke suggested that the central bank would begin tapering down its $85 billion-a-month bond-buying program, and the bond market threw a fit. In a matter of weeks, the yield on the 10-year Treasury bond went to 2.9% from 1.66%.

Further adding to the instability is that, five years after the financial crisis, investors are enthusiatic about stocks. According to the Investment Company Institute, retail investors began yanking money out of fixed income early this year and plowing it into equities at the beginning of this year, reversing a multiyear trend.

"I am a believer in the great rotation" out of bonds and into stocks, Gaffney says.

This may be Gaffney's first bond bear market - many of the prominent managers with experience in such markets have retired - but she has navigated other difficult markets. For those efforts, Gaffney and her former colleagues won the Morningstar Fixed-Income Manager of the Year award in 2009.



Gaffney's tenure at the $72.5 million Eaton Vance Bond started too recently for her to already have her own track record. Nonetheless, she has been active. Her new fund gives her maximum flexibility, and she is putting it to use.

Although the Fed governors surprised observers by failing to announce a tapering of its bond buying at its September meeting, it's only a matter of time before the program ends, she says.

"Whether it's September, October or December, the reality is that they are eventually going to taper." Janet Yellen, who's been nominated to succeed Bernanke, is widely seen as holding his view of the need for central bank stimulus.

Traditional strategies that call for a static allocation to bonds can leave investors holding a falling asset. "When you can identify a trend, you want to ride that trend, and I believe that the biggest trend we're going to see is rising interest rates," she says. Gaffney argues that the 10-year Treasury could be yielding 4% a year from now, up more than 125 basis points from its recent 2.71% yield.



As a result, Gaffney is going where the yields are, even if it's not in bonds. She is permitted to have up to 20% of her fund's holdings in equities; she's now at 15%.

When it comes to stocks, Gaffney is not interested in outsize dividends, but is keen on companies that can grow their dividends over time. "Because corporations have benefited from low rates, this is as good as it gets," she says. "Going forward, there will be more attention paid to reallocating capital to shareholders in the form of dividends."

She likes cyclicals in technology, materials and energy, saying that those sectors are direct beneficiaries of today's improving economy. Applied Materials (AMAT), a maker of chip materials, was hurt by declining demand for personal computers, but has gotten a recent boost from the increased popularity of smartphones and tablets, which bring fresh demand for processors and displays.

With a share price of $17.78 at the beginning of October, Applied Materials has a 2.16% dividend yield. The stock returned 61.7% over the 12-month period that ended on Oct. 4.

Gaffney is also a fan of convertible bonds. It's a way to get exposure to improving corporate fundamentals without taking on the interest rate risk of bonds, she says, because the equity portion prevents the bond price from falling too much on interest rate moves.

One company whose convertibles she likes is Goodyear Tire & Rubber (GT), whose stock was up 80.7% over the 12 months that ended on Oct. 4. "It's a good industrial credit that's really benefiting from the replacement demand for tires," she says.



Among high-yield bonds, which have lost much of their traditional attraction to yield-seeking investors, Gaffney prefers to pick and choose. In the current climate, investor demand has sunk the yield on junk bonds so far that the difference between the yield of a corporate bond and a comparable Treasury reached an all-time low.

"Earlier in the spring, we were piercing 5% for high-yield bonds, which is just a record low and clearly not sustainable," Gaffney says. "You are lending money to a highly levered company, and there needs to be a rate of return to compensate for that risk - and I don't think it's 5%."

So she goes after what she calls fallen angels: bonds that used to have investment-grade ratings, but have taken a tumble. The computer maker Dell is one example. The CEO, Michael Dell, is taking the company private in an effort to retool the once formidable computer giant. To do so, the company took advantage of the low interest rate environment by issuing new bonds. But the flood of new Dell paper caused existing Dell bonds to decline in value and their yields to rise.

Gaffney scooped up those legacy bonds, which yield 8%. "That's a much fairer yield," she says.



Like other fixed-income managers, Gaffney had previously found good value in emerging market debt. In the wake of the financial crisis in the developed markets a few years ago, emerging markets tended to have higher growth rates and lower levels of debt; capital flowed into economies like Brazil, China and India, and away from the U.S. and Europe.

"The emerging markets had the perception that such fast growth was creating a safe haven for investors," Gaffney says.

But more recently, she has reversed course. The U.S. is leading the global economic rebound, Gaffney believes, and growth has cooled in some emerging economies. Her non-U.S. exposure is now just 15%, and about half of that is in Canadian two-year bonds, mainly for liquidity reasons. Her largest holding is Canadian Housing Trust, sporting a 2.95% coupon.

One emerging market where she continues to have a presence is Mexico. Gaffney owns bonds issued by the government and one corporate issue, América Móvil, the telecom giant. Its bonds have a coupon of 6.45% and are due in 2022.



Ilana Polyak, a Financial Planning contributing writer in Northampton, Mass., has also written for The New York Times, Money and Kiplinger's.



Kathleen Gaffney

Eaton Vance Bond

Age: 52

Credentials: B.A. in economics, University of Massachusetts at Amherst

Experience: Portfolio manager, Eaton Vance Bond (2013-present); co-director of investment-grade fixed income, Eaton Vance Management (2012-present); portfolio manager, Loomis Sayles (1992-2012); fixed- income trader, Loomis Sayles (1988-1992); equity trader, Boston Counseling Group (1984-1988)

Ticker: EVBAX

Inception of fund: January 2013

Style: Multi-sector bond

AUM: $72.5 million

Expense ratio: 0.95%

Front load: 4.75%

Minimum investment: $1,000

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