Investors Beware: These Funds Could Pose “Leakage Risk” For Junk Bond Markets


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The time of dreams

Income-oriented funds with the ability to invest in stocks, bonds and loans are holding historically large amounts of cash in risky debt as payments in safe markets remain low. But this trend may not last and investors should take note.

Bank of America

Strategists discovered that these so-called cross funds held $200 billion in high-yield bonds, the highest on record. These funds could pose “leakage risk” as yields on safer bonds begin to look more attractive, they argued 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. Still, most of January’s 2.7% loss was the result of rising Treasury yields, not concerns about corporate borrowers. The market pays only 3.9 percentage points more yield than Treasuries; this gap has averaged 4.6 percentage points over the past decade, and its trough after 2008 was 3 percentage points.

Bank of America argues that cross funds are “potential moderate sellers at current levels and could become a flight risk” as tighter Federal Reserve policy pushes safer yields higher. Funds are also seeing pullbacks, the strategists wrote, so “even though these funds hold [high-yield] allocations unchanged, they may be forced to offload their holdings to meet their own cash flow needs. Strategists predict investors will cut their exposure to high-yield bonds by a quarter when the Fed raises rates.

If the bank is right, these cross funds could add pressure to recent losses in the high yield market. But even if the strategists’ prediction doesn’t come true, the note highlights why investors who own cross-funds should take a hard look at their holdings.

First, investors need to consider what type of high-yield debt their funds hold. There are two main categories, loans and bonds, and the distinction has mattered a lot this year: the leveraged loan market returned 0.4% through February 11, while the high-yield bond market lost 2.7%.

Junk bonds suffered losses because they bear fixed rates, making them vulnerable to tighter Fed policy. Leveraged loans, on the other hand, carry floating rates. So, once the interest rates go above a certain point, the repayments of these loans will also start to increase.

While many fund data vendors break down debt allocations by credit rating, it can be difficult to know whether they are loans or bonds. Take, for example, the T. Rowe Award

Capital Appreciation Fund

(symbol: PRWCX). At the end of 2021, around 12% of its portfolio was invested in loans, according to a representative of the firm, compared to around 5% in high-yield bonds. This leaves it more protected against capital losses when the Fed raises interest rates than it originally seemed.

Another question for flexible funds is whether the fund management can effectively hedge interest rates, even if it holds fixed rate debt.

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

So investors in flexible or balanced funds may also want to examine how a fund manager has fared in previous cycles of rising rates.

One of the largest balanced funds with exposure to high yield markets at the end of last year was the

Hartford Balanced Income Fund

(HBLAX), which held around 6% of its portfolio in risky debt. In the category of flexible funds,

Osterweis Strategic Income Fund

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

Lord Abbett Bond Debenture Fund

(LBNDX) held 29% of its portfolio in US high yield corporate debt. These funds have lost 2.8%, 2% and nearly 4.2% so far this year, respectively, according to Bloomberg data.

The main takeaway from these fund losses is that few markets have been reliable havens during this year’s Fed-fueled rout. All three look good against the S&P 500’s 7.6% decline year-to-date. And investment-grade bonds have fared less well than high-yield debt this year, losing 3.1% through February 11.

Yet the losses also point to one of Bank of America’s warnings. If investors withdraw cash from balanced and flexible funds this year after seeing red on their quarterly statements, they could fuel the liquidation of risky debt.

Write to Alexandra Scaggs at [email protected]


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