Text size
Dreamstime
Income-focused funds with the flexibility to invest in stocks, bonds, and loans hold historically large amounts of cash in junk-rated debt because payouts in safe markets remain low. But that trend may not last, and investors in them should take note.
Bank of America
strategists found that these so-called crossover funds own $200 billion of high-yield bonds, the most on record. Those funds may pose a “flight risk” as yields on safer bonds start to look more attractive, they discussed in a recent note.
The high-yield bond market recently had its worst month since the pandemic, and its second-worst month since the financial crisis, according to ICE Indices. Yet most of January’s 2.7% loss was the result of rising Treasury yields, not worries about corporate borrowers. The market pays only 3.9 percentage points more yield than Treasuries; that spread has averaged 4.6 percentage points over the past decade, and its post-2008 low was 3 percentage points.
Bank of America argues that crossover funds are “potential moderate sellers at current levels and could become a flight risk” as tighter Federal Reserve policy drives safer yields higher. The funds are also seeing withdrawals, the strategists wrote, so “even if these funds hold [high-yield] allocations unchanged, they may be forced to offload holdings to meet their own cash needs.” The strategists predict investors will trim one-quarter of their high-yield bond exposure as the Fed raises rates.
If the bank is correct, these crossover funds could add pressure to the high-yield market’s recent losses. But even if the strategists’ prediction doesn’t pan out, the note highlights why investors who own crossover funds should take a close look at their holdings.
First, investors should ask what type of high-yield debt their funds own. There are two main categories, loans and bonds, and the distinction has mattered a lot this year: the leveraged loan market has returned 0.4% through Feb. 11, while the high-yield bond market has lost 2.7%.
Junk bonds have suffered losses because they carry fixed rates, which leaves them vulnerable to tighter Fed policy. Leveraged loans, on the other hand, carry floating rates. So once interest rates rise past a certain point, those loans’ payouts will start to rise as well.
While many fund-data distributors break down debt allocations by credit rating, it can be difficult to find whether they are in loans or bonds. Take, for example, the T. Rowe Price
Capital Appreciation Fund
(ticker: PRWCX). At the end of 2021, roughly 12% of its portfolio was invested in loans, according to a firm representative, compared with about 5% in high-yield bonds. That leaves it more protected from principal losses as the Fed raises interest rates than it would originally appear.
Another question for flexible funds is whether the fund’s management can efficiently hedge interest rates, even if it owns fixed-rate debt.
While the JPMorgan Income Fund (JGIAX) had a near-30% allocation to high-yield corporate debt at the end of last year, its 1.8% year-to-date loss has outperformed the Bloomberg Barclays Global Aggregate Index’s 3% loss, in part because of its interest-rate hedges, according to a representative.
So investors in flexible or balanced funds may also want to look at how a fund manager has fared during previous rate-hiking cycles.
One of the larger balanced funds with exposure to high-yield markets at the end of last year is the
Hartford Balanced Income Fund
(HBLAX), which had about 6% of its portfolio in junk-rated debt. Within the flexible funds category, the
Osterweis Strategic Income Fund
(OSTIX) had 72% of its holdings in junk-rated investments at the end of 2021, and the
Lord Abbett Bond Debenture Fund
(LBNDX) had 29% of its portfolio in high-yield US corporate debt. Those funds have lost 2.8%, 2%, and nearly 4.2% so far this year, respectively, according to Bloomberg data.
The main takeaway from those funds’ losses is that few markets have been reliable havens during this year’s Fed-fueled rout. All three look good compared with the S&P 500’s 7.6% year-to-date decline. And investment-grade bonds have fared worse than high-yield debt this year, with a 3.1% loss through Feb. 11.
Yet the losses also point back to one of Bank of America’s warnings. If investors pull cash out of balanced and flexible funds this year after seeing red on their quarterly statements, they could add fuel to the risky-debt selloff.
Write to Alexandra Scaggs at alexandra.scaggs@barrons.com
†