It wasn't all that long ago that the bond market seemed destined for destruction. In the last quarter of 2008, investors were dumping fixed income, fearing that the companies would never be able to repay their obligations.

To veteran bond watchers, though, it was the opportunity of the century. "Bonds were trading 20 or 30 cents on the dollar," recalls Kathleen Gaffney, who, along with co-manager Dan Fuss and a team, runs the $18.7 billion Loomis Sayles Bond Fund. The managers recently won Morningstar's Fixed-Income Manager of the Year award.

How times have changed. "Today, those bonds are trading at 80 cents on the dollar," Gaffney says, a bit wistfully.

SLOW RECOVERY

The dramatic turnaround is largely a liquidity story. When investors became less fearful about the economy, they returned to bonds and loaded up, which helped Loomis Sayles Bond, since it was holding the type of paper that suddenly seemed attractive. The bonds that fared the worst in late 2008 were some of the best performers last year, and the fund was well positioned for this event.

While that may seem like cause for celebration-and Gaffney's fund has every reason to celebrate after a stunning 36.7% gain in 2009 that erased the previous year's 22% loss-she is sorry to see the deals disappear. Gaffney's also wary of just how far the prices have moved from the bottom in a short time.

Spread tightening, the bond-geek term for price appreciation, isn't likely to continue. The environment for both the economy and bonds will be subdued, so bond pickers must tread carefully.

"An insatiable demand for yield has pushed up prices in low-quality names," Gaffney explains. "But we expect a very slow and drawn out recovery. That's not a positive for highly levered companies." That leaves Gaffney, Fuss and the team digging a bit deeper and employing their value skills.

FOLLOW THE YIELD CURVE

While Gaffney is not averse to taking some risk in this environment, bonds rated triple-C and worse probably aren't a good idea, since they've rallied past where they traded in the pre-Lehman days. High prices, coupled with ongoing credit problems, mean their upside is limited and disaster could be lurking.

But that doesn't mean that playing it completely safe is the way to go, either. "The Treasury market is unattractive for the long term," she says. Yielding 3.85% in mid-January, there was little room for the 10-year Treasury bond to go anywhere but up. When interest rates rise, Treasuries will be vulnerable to price declines, because bond prices and yields have an inverse relationship.

The middle ground is where Gaffney wants to be, giving her both higher quality names and some protection from rising interest rates. "There is still value in triple-B bonds," she explains. About 35% of her fund contains bonds carrying this credit rating.

For Gaffney's thesis to be right, the yield curve must remain steep. After years of a flat curve-where there was little difference in yield between the shortest-dated paper and the longest-today's steep curve signals economic strength on the horizon. "That has incentivized investors to take risks-the pain of holding cash is just too great," she says.

GOING ABROAD

Gaffney thinks the U.S. dollar will remain weak, continuing its depreciation against the euro and the yen. The ballooning federal deficit is doing its part to pressure the dollar as well, along with predictions of sluggish growth stateside.

So Gaffney doesn't want to take on too much dollar-denominated debt. She and Fuss have long been willing to venture into sovereign debt of other nations. Among their favorites are bonds from Brazil, Mexico and Indonesia, because their economies are expected to grow at a faster clip than the United States'.

Loomis Sayles Bond is watching inflation, too-and again, foreign bonds come handy. Sovereign debt from Australia, Canada and New Zealand is attractive because "these currencies are leveraged to the demand for natural resources, making them an inflation hedge," she says. In all, 27% of the fund's assets are invested in non-U.S. bonds, with Canada accounting for the biggest slice.

JUNK MOVES

Throughout the rebound, Loomis Sayles Bond maintained exposure to bonds rated B and lower. High-yield bonds account for about 20% of the portfolio, although in the fourth quarter of 2008, that number was closer to 35% as Gaffney and her co-managers were unable to resist numerous bargains.

Piling into junk turned out to be a smart move as the spread-or the additional amount of yield that riskier bonds fetch above comparably dated Treasury paper-narrowed dramatically. In late 2008, for example, the spread was at 2,000 basis points. These days, it's closer to 650-still high by historical measures, but a spectacular price improvement.