February 6, 2012 / 10:05 PM / 8 years ago

Strong fund flows drive new US junk-bond funds

NEW YORK, Feb 6 (Reuters) - Money managers and hedge funds have discovered a newfound love for junk.

Legg Mason, First Eagle and Armored Wolf are among institutional investors launching new high-yield “junk” bond funds this month, taking advantage of the surge in investor appetite for risk-taking and yield.

At least seven other firms have launched high-yield funds in the past four months, including Alliance Bernstein, Brookfield and Allianz, according to Lipper data.

The wave of new junk debt portfolios stems from technical and fundamental factors, including reduced investor fear of the U.S. economy plunging into a double-dip recession.

In the past six months through January, high-yield funds, excluding ETFs, had inflows of $8.8 billion, while General U.S. Treasury funds had inflows of just $400 million, according to Lipper.

The junk-bond market’s returns have also been a huge attraction for investors.

Martin Fridson, global credit strategist at BNP Paribas and former chief high yield strategist at Merrill Lynch, notes the Merrill Lynch High-Yield Master II index’s total return of 3.37 percent from the end of December to Feb. 3. That rate, he said, “annualizes to 42.8 percent, and I don’t think anyone’s looking for a return anything like that.”

While Fridson views the 3.37 percent return as a “very big run in a short period of time,” he says high-yield debt could be more attractive than equities, especially if corporate earnings slow.

Yield spreads widened last year as investors became increasingly wary about the credit-worthiness of lower-quality borrowers and rising defaults as deepening fears of a double-dip recession in the United States resurfaced.

Those fears were overblown.

The U.S. corporate debt default rate declined in 2011 compared with the previous two years, according to credit rating agency Standard & Poor’s. At 1.9 percent, the default rate is well below the 4.59 percent historical average and significantly down from a high of 14.5 percent a few years ago.

Also, the potential for contagion in the event of a euro-zone default has declined, some strategists say, as a result of the European Central Bank’s keeping banks afloat through its latest three-year refinancing program.

THE PRO-HIGH YIELD ENVIRONMENT

“There’s a dearth of available yield in other types of bond sectors, especially high quality bonds,” said Miriam Sjoblom, a mutual fund analyst at Morningstar.

The First Eagle High Yield Fund is the firm’s first new fund in 10 years and its first-ever bond fund. The firm’s chief investment officer, John P. Arnhold, said the environment is “relatively benign” for a high-yield fund right now.

“We think the returns relative to the risk are very attractive. We believe we can generate equity-like returns but be better protected by the capital structure,” he said.

Arnhold cited strong corporate profits and moderate economic growth expectations as positive cases for high-yield.

“We think right now we’re in a period of relative stability,” he said, though he noted that “we’re always going to be mindful first and foremost of risk.”

Legg Mason Global Asset Management has also joined the move toward high-yield with the Permal Hedge Strategies Fund, a fund of hedge funds that invests in a range of bond strategies. Javier Dyer, portfolio manager for the fund, cited an increase in corporate activity in 2012 as a reason to enter the field.

John Brynjolfsson, founder of hedge fund Armored Wolf, is launching a junk-bond fund this month after adding to its high-yield capabilities in recent months, including allocating discretionary capital, and structuring private products for outside investors.

“Within a certain range, the deceleration in corporate earnings is positive, because it makes equities less attractive and high-yield more attractive relatively,” said BNP’s Fridson.

So long as companies avoid default, investors can pile into the high-yield sector and gain returns that are less prone to the volatility that affects equities.

Corporate earnings “would have to have a very significant drop-off before you’d have to be concerned about companies being unable to pay their interest,” said Fridson.

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