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BOSTON (Reuters) - If you're looking for top performing U.S. junk bond funds, pick one that's maxed out in stocks.
Bond-fund managers at Loomis Sayles, Fidelity and Eaton Vance are trouncing their benchmarks and almost all their peers by taking advantage of asset allocation rules that permit as much as 35 percent of their holdings in stocks.
"Prices are sky high in all sectors of the fixed income market," said Matthew Eagan, a portfolio manager at the $18 billion Loomis Sayles Strategic Income Fund. That's why Eagan and some of his competitors are boosting returns by buying stocks and building on existing positions that deliver a one-two punch of dividend yield and capital appreciation.
Eagan's bond fund has a 1-year return of 7.92 percent, easily beating the 0.21 advance of its benchmark index and better than 98 percent of its peers in the multisector bond category, according to Morningstar Inc. Its No. 2 overall holding, shares of Corning Inc, have surged 18 percent this year and 41 percent in the past 12 months.
Doing even better is the Eaton Vance Bond Fund, whose 1-year return is 9.81 percentage points higher than its benchmark. It is the best performing multisector bond fund with a 1-year return of 10.02 percent, according to Lipper Inc, a Thomson Reuters company. The $664 million fund's portfolio is about 16 percent to 18 percent invested in stocks, portfolio manager Kathleen Gaffney said.
During last month's sell-off of momentum stocks such as biotechnology companies, the Eaton Vance fund took advantage of the stock market dip by adding to existing stock positions, Gaffney said. The fund's largest stock holdings include Ingersoll-Rand PLC, Regions Financial Corp, SLM Corp and Kinder Morgan Inc.
Fidelity Investments junk bond fund manager Mark Notkin said the earnings yield of stocks in the S&P 500 Index is now about 6.25 percent. That's better than the 5.2 percent yield of junk bonds, which typically have the highest yields in the bond market.
Earnings yield is the inverse of a stock's price-to-earnings ratio and shows the percentage of each dollar invested in the stock that was earned by the company. It's calculated by dividing the earnings per share for the most recent 12-month period with the current market price per share. The earnings yield on S&P 500 stocks has been beating junk bond yields ever since the beginning of the economic recovery, with some of the most pronounced gains coming this month, according to Reuters data.
"Historically, if you look back 25 years, high-yield would be several hundred basis points more than the earnings yield of the S&P 500," Notkin said. "Now, the S&P is a 100 basis points more than the high-yield market. That isn't a little off-kilter, but substantially off-kilter."
Notkin said that's a reason to buy stocks, which he said could outperform junk bond yields for the next two to three years.
The Lipper Core Bond Funds index is up 0.11 percent for the 1-year period, as of May 2. And that same index is up 3.2 percent year to date, as of May 2.
To be sure, bond fund managers still have to be able to pick the right stocks.
The Pioneer High Yield Fund, whose portfolio managers declined to comment, hit some turbulence in the first quarter with its stock selection. The portfolio's allocation to equities was the largest detractor from relative returns. The fund's Class A shares returned 2.6 percent in the quarter, compared to the 3 percent return on the Bank of America Merrill Lynch High Yield Master II Index.
One of the fund's stock picks, General Cable Corp, is down 19 percent this year after the company said its income from Venezuela would fall because of changes in the currency exchange rate, pricing controls and social unrest in that country.
Some multisector and junk bond funds have the flexibility in their mandates to buy stocks and preferred stocks in addition to their holdings of bonds of all stripes. Eagan's fund at Loomis Sayles, for example, can hold as much as 35 percent of its assets in preferred stocks and dividend-paying common stocks.
The $10.3 billion Fidelity Capital & Income Fund run by Notkin, has been maxed out for several quarters with almost 20 percent of its portfolio in stocks, according to its latest fund disclosure.
Notkin's bet on Station Casinos was a top contributor to the Fidelity fund's first-quarter performance after the casino operator got a lift from better-than-expected results from its Las Vegas operations.
United Rentals Inc, a top stock holding in Notkin's fund, has climbed 18 percent in the past three months as a recovery in the commercial construction industry boosts demand and rental rates for the company's equipment.
Notkin's fund has been on a winning streak for a long time, posting a 5-year average annual return of 16.93 percent, compared to the benchmark average annual return of 4.89 percent, according to Morningstar.
That puts Notkin's fund in the top 97 percent in high-yield bond category. The fund's 1-year return of 7.59 percent has been helped by avoiding pricey high-yield debt that's trading above par.
Bond fund managers who venture into the stock market tend to be value investors, hunting for large-cap, dividend-rich stocks that come with solid balance sheets and strong cash flow.
"I stay away from the high flyers," Eaton Vance's Gaffney said. She added that stocks shelter part of her portfolio from the interest-rate risk that can hurt a bond fund's performance.
If a stock has a dividend yield of around 4 percent, it's fine with some bond fund managers if its share price does little in the way of appreciation.
"Four percent is shaping up to be a good number for all bond managers in 2014," said Eagan at Loomis Sayles.
Reporting By Tim McLaughlin