August 12, 2014 / 5:32 PM / 3 years ago

Panicky U.S. junk bond investors flee funds despite good returns

BOSTON, Aug 12 (Reuters) - Investors fleeing the U.S. junk bond market at a record pace this summer are punishing some of the sector’s best-performing funds, while some middle-of-the-pack peers are unscathed.

Net withdrawals from U.S. junk bond mutual funds totaled a record $5.8 billion during the first week of August, according to Lipper Inc, a unit of Thomson Reuters. The sell-off followed the withdrawal in July of an estimated $6.8 billion from junk bond mutual funds, whose main holdings of corporate junk bonds are being treated as overvalued.

The outflows from junk bond funds, which were the biggest since Lipper records began in 1992, underscore growing investor concerns of stretched valuations in the securities after the sector’s multi-year rally.

Hardest hit among funds with at least $1 billion in assets was the $4.1 billion Fidelity Strategic Advisers Income Opportunities Fund, whose $549 million in outflows in July decreased assets under management by 11.6 percent from the end of June, according to Lipper. But the fund’s year-to-date total return of 4.43 percent beats 83 percent of peers, according to Morningstar Inc data.

The fund invests in other junk bond funds run by Fidelity and by outside managers, including T. Rowe Price Group Inc .

In contrast, the $3.1 billion Columbia Income Opportunities Fund had $199 million in net deposits from investors during July, increasing its assets by 6.6 percent, according to Lipper. The net increase was best among junk bond mutual funds with at least $1 billion in assets.

But the Columbia fund’s year-to-date total return of 3.66 percent is lagging 51 percent of peers, according to Morningstar.

The flight from junk bond funds has come as unusually low yields and high prices for junk bonds had prompted many observers to speculate that a bubble was forming, in no small part because of U.S. Federal Reserve policies that kept interest rates on bonds of all stripes at historic lows.

Three rounds of bond-buying by the Fed and an official policy interest rate near zero for almost six years have forced investors to look for greater returns among a wide range of riskier assets, including junk bonds and equities.

The bet had paid off handsomely, with junk bonds delivering a total return of 135 percent over the five years through the end of 2013. Until early July, junk bonds had been outperforming Treasuries by more than 200 basis points, but they are now outpacing Treasuries by just 45 basis points.

Drawn by the opportunity to borrow at such favorable rates, low-rated U.S. corporate borrowers have been issuing new debt at a rapid pace. So far in 2014, U.S. companies have issued $197.4 billion of new junk bonds, 1.7 percent ahead of the 2013 pace, according to data from the Securities Industry and Financial Markets Association.

Meanwhile, several junk bond funds with flexible mandates that allow them to load up on individual stocks are outperforming peers by a wide margin.

The $10.5 billion Fidelity Capital & Income Fund run by Mark Notkin is a junk bond fund with about 20 percent of its assets in stocks.

The fund, which also makes up about 15 percent of the assets in Fidelity’s Strategic Advisers Income Opportunities Fund, has generated a 6.01 percent year-to-date return, beating the high-yield bond fund average of 3.6 percent, according to Morningstar Inc. That puts the fund at No. 5 among junk bond funds.

The sector’s No. 2-ranked fund, the Loomis Sayles Institutional High Income Fund, has a year-to-date return of 8.10 percent. Its second-largest holding at the end of July was Corning Inc, whose stock is up 13 percent so far in 2014.

Notkin said he has built up his fund’s position in stocks largely because the earnings yield of the S&P 500 index is more than 6 percent. That’s better than the 5.3 percent yield of junk bonds, which typically have the highest yields in the bond market.

“That’s a very unusual relationship if you go back 25 years,” Notkin said.

Junk bond yields usually are several hundred basis points higher than the S&P 500 Index’s earnings yield, which is a close approximation of a company’s free cash flow. (Reporting by Tim McLaughlin; Editing by Leslie Adler)

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