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Fund Spy

3 Good Funds With Big Credit Risks

Don't expect funds that have fared well during the rally to hold up during a correction.

This article was published in the May 2014 issue of Morningstar FundInvestor. Download a complimentary copy of Morningstar FundInvestor here.

No fund strategy can succeed in every market envi­ronment, but investors who know what to expect can put inevitable slumps to good use by adding to (or at least just sticking with) their underachievers. Recent history underscores the virtues of patience: The funds that soared highest during 2009’s rally, after all, typically ranked among their catego­ries’ laggards during 2008’s stampede into quality.

The Morningstar Medalists below placed in the bottom half of either the high-yield bond or bank-loan categories in 2008 but fared much better in 2009. Particularly in the case of the two high-yield funds, that performance was largely predictable. Plenty of credit risk comes baked into their category, but those funds haven’t just courted that risk, they’ve embraced it: Historically, their managers have been more willing than most to step down the credit-quality ladder. It was no surprise, then, that when capital markets froze during 2008’s credit crunch, these funds suffered more than most. More than five years into a rally that’s been especially favorable for riskier fare, investors shouldn’t just be prepared for a pull­back, they should be prepared to make the most of it.

 Eaton Vance Income Fund of Boston (EVIBX)
This Silver-rated high-yield-bond fund’s 30.3% loss in 2008 landed in the category’s bottom quintile, dragged down by an overweight slug of B rated bonds. Amid tough economic times, generous exposure to hard-hit leisure-industry debt also dinged results. Comanagers Mike Weilheimer and Tom Huggins stuck to their guns throughout that period, and inves­tors who stuck with them were compensated for their patience. In 2009, a 57% gain placed just outside the peer group’s top decile. In the trailing five-year period through May 2014--a stretch that captures the high-yield market’s dramatic recovery off 2008-09 lows--an annualized gain of 13.7% ranks in the top third.

Huggins left the team in 2012, a year in which Weil­heimer (in place here since January 1996) turned relatively cautious and, perhaps not coincidentally, the fund turned in its first subpar year since 2008. And while it placed in the category’s top quartile in 2011, the fund shed 5.7% during that year’s third quarter, the toughest "stress test" high-yield has faced since March 2009.

 Fidelity Capital & Income (FAGIX)
Managed since 2003 by Mark Notkin, this Silver-rated high-yield bond fund is super aggressive. Versus a category norm of less than 2%, its current equity stake hovers near 19%. And while its allocation to CCC rated bonds isn’t especially high right now, Notkin has been willing to invest significantly in them in the past.

The fund’s returns have been nearly as predictable as its volatility. Like Eaton Vance Income Fund of Boston, it placed in the category’s bottom quintile in 2008 with a loss of 31.9%. It shed 10.8% in 2011’s third quarter, too. During 2009’s junk rally, though, the fund sailed past not only the Eaton Vance fund but also virtually all category rivals, securing a spot in the peer group’s top percentile with a gain of 72%.

 Eaton Vance Floating Rate (EVBLX)
This Silver-rated fund strikes a milder profile than most of its bank-loan category peers. It still slipped into the category’s bottom half in 2008, though, suffering a loss of 30.4%. And while it outperformed most peers in 2011’s third quarter, the fund shed 3.1% of its value nonetheless.

More worrisome is the pace of inflows for the broad bank-loan category; amid investors’ mad scramble for yield, assets rose to nearly $143 billion in May 2014 from $97.5 billion 12 months prior. When the market corrects, this fund will probably fare better than most, though it likely won’t escape unscathed.

This article was previously published while Shannon Zimmerman was employed by Morningstar, Inc. as the Director of Training, Fund Research. Mr. Zimmerman is currently employed by Morningstar Associates, LLC, a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The information, data, analyses, and opinions presented here do not constitute investment advice on behalf of Morningstar Associates; are provided as of the date written and solely for information purposes. This content is not an offer to buy or sell a security and is not warranted to be correct, complete or accurate.

Shannon Zimmerman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.