Investors beware: these funds could pose a “flight risk” for the junk bond markets

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Income funds with the flexibility to invest in stocks, bonds and credit have historically held large amounts of cash in junk-rated debt as payouts remain low in safe markets. But this trend may not last, and investors should take note.

Bank of America

Strategists found these so-called crossover funds own $200 billion in high-yield bonds, the most ever. These funds could pose a “flight risk” as yields on safer bonds look more attractive, they argued in a recent statement.

The high yield bond market recently had its worst month since the pandemic and second worst month since the financial crisis, according to ICE indices. However, most of January’s 2.7% loss was the result of rising Treasury yields rather than worries about corporate borrowers. The market pays only 3.9 percentage points more yield than Treasuries; This spread has averaged 4.6 percentage points over the last ten years and its low after 2008 was 3 percentage points.

Bank of America argues that crossover funds “are potentially moderate sellers at current levels and could become a flight risk” as tighter Federal Reserve policy pushes safe yields higher. The funds also see withdrawals, the strategists wrote, so “even if these funds hold.” [high-yield] With allocation unchanged, they could be forced to shed holdings to meet their own liquidity needs.” The strategists predict that investors will trim a quarter of their exposure to high yield if the Fed hikes rates.

If the bank is right, these crossover funds could add pressure to the high yield market’s recent losses. But even if the strategists’ prediction doesn’t work out, the note shows why investors who own crossover funds should take a close look at their holdings.

First, investors should ask themselves what kind of high-yield bonds their funds own. There are two main categories, loans and bonds, and the distinction was very important this year: the leveraged loan market is up 0.4% through Feb. 11, while the high yield bond market is down 2.7%.

Junk bonds have suffered losses because they are fixed income, making them vulnerable to more hawkish Fed policy. Leveraged loans, on the other hand, have variable interest rates. So once interest rates rise above a certain point, payouts on these loans will also rise.

While many fund data providers break down debt allocation by credit rating, it can be difficult to determine whether it’s loans or bonds. Take the T. Rowe Price, for example

capital appreciation fund

(Ticker: PRWCX). At the end of 2021, about 12% of the portfolio was invested in credit, compared to about 5% in high-yield bonds, according to a company representative. This gives it better protection against capital losses if the Fed hikes interest rates than it initially appeared.

Another question for flexible funds is whether the fund management can efficiently hedge interest rates even if it has fixed-rate debt.

While the JPMorgan Income Fund (JGIAX) had a nearly 30% allocation to high-yield corporate bonds late last year, its 1.8% year-to-date loss has outpaced the 3% loss in the Bloomberg Barclays Global Aggregate Index, in part due to its interest rate hedges, so a representative.

Investors in flexible or mixed funds should therefore also look at how a fund manager has fared in previous rate hike cycles.

One of the larger balanced funds with exposure to high yield markets late last year is the

Hartford Balanced Income Fund

(HBLAX), which held about 6% of its portfolio in junk-rated debt. Within the flexible fund category, the

Osterweis Strategic Income Fund

(OSTIX) had 72% of its holdings in junk-rated assets at the end of 2021, and the

Lord Abbett Bond Debenture Fund

(LBNDX) had 29% of its portfolio in US high yield corporate bonds. According to Bloomberg data, these funds are down 2.8%, 2% and nearly 4.2% respectively so far this year.

The key takeaway from these funds’ losses is that few markets have been reliable havens during this year’s Fed-driven flight. All three are looking good compared to the S&P 500’s 7.6% year-to-date decline. And investment-grade bonds have underperformed high-yield bonds this year, down 3.1% through Feb. 11.

But the losses also indicate one of Bank of America’s warnings. As investors pull cash from balanced and flexible funds this year after seeing red in their quarterly reports, they could fuel the sell-off in risky debt.

Write to Alexandra Scaggs at [email protected]

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