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BOSTON (Reuters) - U.S. corporate bond funds this year are adding Treasuries to their holdings at more than twice the rate of corporate debt amid concern that the struggling European economy and potential changes in Federal Reserve policy will drag down profits at U.S. corporations.
Through September, corporate bond portfolios boosted their holdings of U.S. government debt by 15 percent, compared with a 6.5 percent increase in corporate bonds during the same period, according to Lipper Inc data. The funds now hold about $13 billion in Treasuries, 15 percent more than the $11.3 billion they held at the end of 2013.
Corporate bond funds typically invest in a range of debt that includes mortgage-backed securities, U.S. Treasuries and bonds backed by student loans, credit cards and auto loans. Some corporate junk bond funds have guidelines that allow them to buy individual stocks. The move to buy Treasuries, which are more easily traded than most corporate bonds, show that managers anticipate market turmoil that could lead to redemption demands from investors.
Matt Toms, head of fixed income at New York-based Voya Investment Management, said he has cut exposure to corporate bonds in favor of mortgage-backed securities, for example. In particular, he has reduced corporate debt issued by U.S. financial companies because of their exposure to the weak European economy. He sees mortgage-backed bonds as more U.S.-centric because they are backed by the ability of American homeowners to make good on their monthly mortgage payments.
"The volatility in Europe could translate more quickly through the corporate debt issued by U.S. banks," Toms said.
A year ago, the Voya Intermediate Bond Fund's top 10 holdings included debt issued by Morgan Stanley, JPMorgan Chase & Co and Goldman Sachs. But more recently, none of those banks' debt cracked the top 10 holdings of the fund, disclosures show.
Toms, who runs the $1.9 billion Voya Intermediate Bond Fund, said nearly two-thirds of the portfolio's assets are in government bonds or government-related securities.
"That's a highly liquid pool," he said.
Michael Salm, co-head of about $60 billion in fixed-income assets at Putnam Investments, said slumping energy prices could also increase the rate of corporate defaults among junk-rated energy companies. He also said he sees subtle deterioration on the balance sheets of corporations outside the financial sector. He didn't talk about any specific energy companies on the cusp of default and said company policy prohibits him from talking about individual securities.
"They're starting to use leverage more, they're starting to do things that are less bondholder-friendly," said Salm, whose $1.7 billion Putnam Income Fund generated a 6.88 percent return during the 1-year period that ended Sept. 30. That was fifth best among core bond funds, according to Lipper.
Some corporations have been issuing new debt to repurchase more of their own stock, which is viewed as a negative for bondholders. In June Fitch downgraded Monsanto's issuer default rating to "A-" from "A" after the company announced a new two year $10 billion share repurchase program. Bond fund managers would rather see the money be invested in activities that boost cash flow and growth, for example.
To be sure, the average amount of corporate debt in corporate bond funds rose to 52 percent of current assets from 48.6 percent at the end of last year, according to Lipper, Inc, a unit of Thomson Reuters.
One trouble is that it's become harder than ever to buy and sell corporate bonds in the secondary market as new regulations and capital requirements since the financial crisis forced Wall Street banks to slash their inventories. That has left a vacuum in matching buyers and sellers, and bond managers say they don't want to get caught holding too much of it in a rout.
"Everyone sees the lack of liquidity as a potential risk in the corporate bond market," said Sumit Desai, the lead analyst for corporate credit funds at research firm Morningstar Inc. "But there hasn't been a major event to test the market."
The value of corporate bonds held by U.S. mutual funds has more than doubled since 2007 to about $1.7 trillion. Corporate bond issuance during the first nine months of 2014, driven by rock bottom interest rates, was $954 billion, compared with $1.08 trillion in the year-ago period, according to the Financial Industry Regulatory Authority.
Still, trading volumes have stayed about the same, according to research from BlackRock Inc, the world's largest asset manager.
"Liquidity stinks," Toms said of corporate bonds.
Last week, sales surged of 10-year Treasury notes in a flight to safety caused by weak signals from the U.S. economy. The yield on the benchmark note fell below 2 percent as the stock market gyrated.
Loomis Sayles portfolio manager Matt Eagan said his $19 billion Strategic Income Fund is close to having a record level of reserves, largely in the form of government bonds. U.S. Treasuries account for about 16 percent of the portfolio, a four-fold increase since the end of 2013, he said.
He said the fund has also cut exposure to the lowest rated corporate junk bonds because he doesn't believe he was getting paid for the risk he was taking.
"We're giving up some yield to preserve the ability to be flexible," Eagan said.
But he is still hunting for home runs. For a more aggressive investment strategy, the bond fund manager said he bought shares from the IPO of Chinese commerce company Alibaba Group Holding Ltd at $68 and then sold them at $91, for a quick 34 percent gain.
"It definitely added to our performance," said Eagan, who bought the shares for the Loomis Sayles Strategic Alpha Fund, which has a mandate to invest in a wide range of fixed income and stock holdings.
At Fidelity's $10.5 billion Capital & Income Fund, portfolio manager Mark Notkin made a similar play, adding Alibaba to a subportfolio of stocks that make up about 20 percent of the fund's overall assets. In the third quarter, the fund's stocks outperformed the junk bonds. Alibaba's stock was a top 10 holding in the fund at the end of September, fund disclosures show.
Reporting By Tim McLaughlin; Additional reporting by Ross Kerber; Editing by Richard Valdmanis and John Pickering