When Giant Bond Funds Juice On Junk: Fed Destruction Of Honest Price Discovery Is Complete

By Matt Wirz at The Wall Street Journal

May 27, 2014 8:44 p.m. ET

A handful of managers have elbowed their way to the top of the bond-fund world by loading up on riskier debt.

Among the 10 largest U.S. bond funds at the end of 2013, the four with the fastest growth in assets since 2008 held an average 20% of their investments in bonds rated below investment grade, also known as junk bonds, according to an analysis by The Wall Street Journal of data from Morningstar Inc.

The development underscores the intense demand for investment returns that has characterized the financial markets since the 2008 crisis. Prodded by uneven economic growth, expansive central-bank policy and low interest rates, investors are gobbling up riskier assets like never before.

The biggest bond funds, led by Bill Gross's $230 billion Total Return Bond Fund at Pacific Investment Management Co., have long relied on safe, high-rated government and corporate debt. But in the era of record-low interest rates engineered by the Federal Reserve, money has flocked to fund managers who have bought into lower-rated debt such as junk bonds, emerging-market debt and mortgage securities.

"Who wants an index fund that yields 2%?" said Jeffrey Gundlach, whose Total Return Bond Fund at DoubleLine Capital LP has $32.1 billion under management, up 10 times from its start four years ago. Mr. Gundlach, in an interview, said investors "want exposure to these high-yield and distressed securities and they've become comfortable with what we're doing."

Junk bonds typically offer investors a higher interest rate, or yield, to make up for the risk of default. The strategy particularly paid off last year, when investors fled risk-free government bonds and higher-grade corporate bonds as U.S. interest rates rose.

High-yield corporate bonds returned 7.44% in 2013, including interest payments and price gains. The Barclays U.S. Aggregate bond index, which includes no junk-rated debt, lost 2% last year....

Investors in junk corporate bonds like Mr. Lee draw comfort from low corporate default rates below 2%, but the chase for yield has pumped junk-bond prices up to near-record highs, leaving them susceptible to selloffs, analysts said. Mr. Lee said he is watchful for investors to pull out of the market should they sour on bond funds, as they did last summer.

"The air goes out of the balloon faster than it goes in, so we might add another percent or two of cash or Treasurys to our portfolio," he said.

One concern for regulators is that if hit with a wave of redemptions from investors, the funds could have trouble unwinding their bets in the smaller high-yield markets, where trading can dry up quickly when prices start to fall.

"Sales of assets from any of those funds could create contagion effects on the related funds, spreading and amplifying the shock and its market impacts," the Treasury said in a September report on the systemic risk posed by large fund managers.....

"We've gone out the risk spectrum some," said Mr. Lee, who began buying high-yield mortgage bonds and corporate bonds aggressively in 2009 when their prices collapsed. "The fundamentals of corporate America are still pretty good and default rates are pretty low."

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