| NEW YORK
NEW YORK Once named Canada's "Stockpicker of the Decade" by fund tracker Morningstar, Francis Chou now runs the top-performing bond fund in the United States. But it may also be one of the riskiest.
His $6.6 million Chou Income fund - so new and so small that neither Lipper nor Morningstar will rate it - has returned an eye-popping 39 percent over the past year, including a 14 percent jump since the start of January.
"I'm looking at numbers that I can't believe I'm seeing for a bond fund," said Todd Rosenbluth, director of mutual fund research at S&P Capital IQ, who analyzed the fund at the request of Reuters.
Yet the fund's short track record shows that Chou's investors should be ready for stunning underperformance as well. Each full year since the fund's 2010 launch, returns have come in more than 20 percentage points above or below its benchmark, according to Morningstar data.
In 2012, its performance was 30.3 percentage points stronger than the benchmark Barclays U.S. Aggregate Bond index, and 26.4 percentage points stronger than the average among the 333 funds in its Morningstar category. It outperformed the largest bond fund, PIMCO's Total Return, by 24.2 points.
But in 2011, when the fund fell 13.8 percent, it came in 21.6 percentage points below the benchmark, and 18 points behind PIMCO Total Return.
"You don't end up in the top and the bottom in consecutive years by being a plain-vanilla bond fund," said Rosenbluth. "This fund is taking on risk, and it's been rewarded for it right now."
It has been a dramatic turn for the press-shy former telephone repairman who turned to stock investing in 1981 after reading books on value investing by Benjamin Graham. Chou, 56, immigrated to Canada from his native India in 1976, and started an investing club among his Bell Canada co-workers five years later.
He launched his first stock fund, the now-$469 million Chou Associates fund, in 1986. The fund gained an annualized 17.3 percent for the 10 years ending in October, 2004, compared with a 7.8 percent return for the Morningstar Canada Equity Mutual Fund index. Since then, the fund has gained an annualized 6.48 percent per year, compared with a 3.7 percent average among its peers over the same time.
Chou now runs a lineup of five mutual funds from his Toronto office, including stock funds that focus on Europe and on Asia. Investors can purchase stakes in the funds either directly or through an advisor. In his bond fund, he has been benefiting from handful of securities that he bought in 2011 when they were "mispriced", he said. Now, he's been moving more money into cash because the high-yield market looks overpriced.
"The bargains are not as cheap as they once were, and you have to be more careful now," he told Reuters in a rare interview.
CONVERTIBLE DEBT PAYS OFF
Chou owes his above-average performance over the last year in part to significant stakes in bonds issued by New Jersey-based biotech Mannkind Corp and North Carolina-based marketing company R.H. Donnelley. R.H. Donnelley has since changed its name to Dex One Corp after going through a Chapter 11 restructuring.
Chou bought both securities in 2011, when Mannkind was trading at about 57 cents on the dollar and R.H. Donnelley was trading at 31 cents, he said. Each fell further after he bought them, contributing to his poor 2011 performance, he said. The bonds rebounded over the last year, with Mannkind now trading at 90 cents on the dollar and R.H. Donnelley trading at 71 cents on the dollar.
"The only thing we can do is buy them cheap," he said. "So be it. You can't know where the bottom is."
Overall, Chou's fund has some 36 percent of its assets in unrated convertible bonds, according to S&P Capital IQ. The securities pay interest, like bonds, but can be converted into stock under certain conditions. Convertible bonds often allow companies whose bonds are rated below investment grade to raise money at lower interest rates.
In 2012, Chou's holdings in Catalyst Paper Corp were converted into a combination of new bonds and common shares, while the fund's holdings in Abitibi-Consolidated were converted into common shares of the pulp and paper company, which is now named Resolute Forest Products Inc.
Convertible bonds were responsible for the fund's largest loss in 2012 as well. Compton Petroleum Corp restructured its debt as the price of natural gas plummeted, and the common shares the fund received were "far below" the price that Chou had paid for them, according to the fund's annual report.
The remainder of the portfolio consists of investments in bank loans and corporate bonds, with another 31 percent of the assets in cash, a high level that reflects Chou's skepticism about the junk bond market extending its rally.
"Non-investment grade debt securities are fully priced and in general, I would stay clear of them ... the possibility of a large, permanent loss of capital is extremely high," Chou said in his most recent letter to investors.
The level of cash may remain high, he said. Mispriced bonds are harder to find than mispriced stocks simply because there are fewer bonds issued, Chou said.
He said he will only invest in a security if he feels he has a comfortable margin of safety, though he declined to explain his investment philosophy in detail other than to say that he concentrates on the North American market because of its transparency. The fund will continue to have a concentrated portfolio as well, he noted.
Chou is equally oblique regarding the investors in his fund. He says he doesn't know who they are, and that he has no plans to promote the fund to prospective clients, relying instead on word of mouth.
"I prefer to go slow and steady," Chou said. "In the bad years you want to make sure you have reserve capital, and this year looks like it's already fully priced."
(Reporting By David Randall; Editing by Chelsea Emery, Frank McGurty, Peter Galloway and Tim Dobbyn)