U.S. loan funds gain $1.2 billion as Fed sparks fears of rising rates

NEW YORK Fri May 24, 2013 3:02pm EDT

The company logo of the Bank of America and Merrill Lynch is displayed at its office in Hong Kong March 8, 2013. REUTERS/Bobby Yip

The company logo of the Bank of America and Merrill Lynch is displayed at its office in Hong Kong March 8, 2013.

Credit: Reuters/Bobby Yip

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NEW YORK (Reuters) - Investors worldwide poured $1.2 billion into corporate loan funds based in the United States in the latest week as signs the Federal Reserve could scale back on stimulus sparked fears of rising U.S. interest rates, according to Bank of America Merrill Lynch.

The inflows in the week ended May 22 elevate this year's total cash gains into loan funds to $26.6 billion, according to Bank of America Merrill Lynch, which cited figures from fund-tracking firm EPFR Global. Corporate loans - also known as leveraged loans - are protected from rising interest rates by being pegged to floating-rate benchmarks.

Federal Reserve Chairman Ben Bernanke told Congress on Wednesday that the central bank could reduce the pace of its asset purchases at one of its "next few meetings" if the U.S. economic recovery looked set to maintain momentum. Minutes from the Fed's latest April 30-May 1 meeting showed, however, that some officials were open to reducing stimulus by as early as June.

The Fed is buying $45 billion in Treasury bonds and $40 billion in agency mortgage bonds per month in an effort to spur hiring and lower long-term borrowing costs. The central bank plans to keep stimulus in place until the U.S. unemployment rate falls to 6.5 percent or inflation breaches 2.5 percent.

Some investors believe that the Fed gave clear signals that it will taper its easing program this year. "What the Fed is doing is telling the market, 'prepare yourselves'," said Michael Temple, senior vice president at Pioneer Investments. "They're sending up trial balloons."

Temple said interest rates will rise as investors sell bonds in anticipation of a scaling back in Fed easing, which he thinks the Fed could begin doing in the fourth quarter of this year. He has a "short" bet against the 10-year Treasury in his Pioneer Absolute Return Credit Fund, and said he likes corporate loans for their protection against rising rates.

The Standard & Poor's/LSTA U.S. Leveraged Loan 100 Index, which tracks the largest institutional leveraged loans, has earned a 3.2 percent return this year, and has a current yield-to-maturity of 5.02 percent. The yield to maturity is the rate of return expected on a bond if it is held until maturity.

High-yield junk bonds, which are not protected from rising interest rates, have outperformed corporate loans so far this year while offering higher yields. The Barclays US Corporate High Yield Index has earned a return of 5.01 percent this year. The yield-to-worst on the index, which fell to a record low of 4.97 percent on May 7, has since risen to 5.4 percent. Rising yields indicate falling prices.

Yield-to-worst indicates the lowest potential yield on a bond without the issuer defaulting.

Funds that hold high-yield debt pulled in $1.1 billion in new cash in the latest week, showing an increase in demand from the prior week's meager $100 million in cash gains, according to Bank of America Merrill Lynch and EPFR Global.

The latest gains into high-yield bond funds, however, are still middling compared to consistently high inflows into the funds last year, said Christopher Hays, credit strategist at Bank of America Merrill Lynch. High-yield bond funds globally attracted a record $72 billion in new cash in 2012, according to Bank of America Merrill Lynch and EPFR Global.

The latest inflows into loan funds and high-yield bond funds accounted for more than half of the total inflows of $4.49 billion into all bond funds over the week, according to EPFR Global. Those total cash gains were up from inflows of $3.4 billion into bond funds the prior week.

Stock funds, meanwhile, saw a sharp drop in demand as $7.49 billion flowed into the funds, down from big inflows of $14.16 billion the previous week. The benchmark S&P 500 fell 0.21 percent over the latest weekly period on concerns of a pullback in Fed easing.

Investors are pulling back somewhat from U.S. stocks in anticipation of a correction, said Michael Jones, chief investment officer of RiverFront Investment Group. The S&P 500 had risen over 16 percent from the start of the year to Wednesday.

Funds that hold Japanese stocks had inflows of $3.04 billion, down from record-high inflows of $6.79 billion the previous week. The Nikkei average had risen 80 percent from last November to Wednesday. Shinzo Abe, who was elected Japan's prime minister in late December, boosted the index by proposing aggressive monetary and fiscal policies in mid-November.

The Bank of Japan announced on April 4 that it would inject $1.4 trillion into the nation's economy in less than two years to fight deflation. The index, which hit a 5-1/2-year high of 15,381.02 on Tuesday, rose 3.5 percent over the reporting period. The index suffered a pullback of 7.3 percent on Thursday, however, in its biggest one-day drop since a slide two years ago in the wake of a tsunami.

Japanese stocks are set to recover from the latest correction, said Jones of RiverFront, who said the nation's stocks are undervalued. "We still think there's plenty more to go in Japan," he said.

(Reporting by Sam Forgione; Editing by Phil Berlowitz)

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