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Time to Trim Junk-Bond Holdings

The leading high-yield manager of 2009 says these bonds are getting expensive.

A fund manager wedded to one sector of the market will almost always have something sunny to say about his spouse. Ask a tech-fund manager for a prognostication on tech stocks and you’ll surely receive a rose-colored response, just as you would from managers of technology funds or health-stock funds about their chosen sectors.

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Managers who are exceptions to that rule are often worth listening to. That’s why it’s notable that Mark Notkin, manager of 2009’s best-performing high-yield-bond fund, Fidelity Capital & Income (symbol FAGIX), has been selling some of his junk-bond holdings and redeploying cash to stocks. The reason for Notkin’s moves is plain: “Valuations in the high-yield market look full,” he says.

Notkin’s record adds weight to his words. From the time he took the fund’s helm in mid 2003 through January 14, it returned 9.6% annualized, beating more than 99% of its peers. Granted, Notkin tends to be more aggressive than the typical junk-fund manager, venturing into the lowest-rated bonds and into deeply subordinated debt (bonds whose holders, in a bankruptcy scenario, are last in line to be paid).

But he can also position the fund defensively and allow cash to build -- as he did in 2008, when cash holdings peaked at 20% of assets by the end of the year. That helped to contain 2008 losses to 31.9% (although that was still much worse than the average junk-bond fund’s decline of 26.0%). That also meant he had dry powder to put to work in early 2009, allowing him to add to junk holdings when prices were near bottom. The fund gained 72.1% for the year, well ahead of the average junk-bond fund’s gain of 46.8%.

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To be clear, Notkin isn’t predicting doom for the sector. “I think the economy will slowly heal itself over 2010 and will return to a slow-growth environment,” he says. Against such a backdrop, most junk bonds will continue to pay their coupons, with prices holding their ground. But given that the junk market is currently pricing in a lasting economic recovery, anything less -- such as a double-dip recession -- “would be a shock to any market that has risk in it,” including junk, Notkin says. “That’s why I think this is a time not to be greedy and to pare positions.”

In addition to the money he’s putting in stocks -- which represented 12% of assets at last report but have at times climbed to 20% of assets -- Notkin is buying bank loans. Bank loans are junk-rated debt securities that are senior to other debt instruments and typically secured by cash or other assets, providing investors with a decent safety net in a bankruptcy. But what make bank loans particularly appealing are their “floating” interest rates, which reset every few months with changes in certain short-term interest-rate benchmarks. That means bank loans hold up unusually well when rates are rising.

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Although Notkin is concerned about the prospect of an inflation-driven rise in interest rates eating away at his fund’s returns, he points out that high-yield bonds hold up much better in such a scenario than many other types of bonds. “The higher a bond’s quality, the more sensitive its price to interest-rate movements,” he says. So, for example, a one-percentage-point rise in ten-year Treasury rates over the next year would pull Treasury investors’ total return into the red. But for high-yield investors, “it would cost you maybe 4.5% to 5% of principal, but you would still end up with a low-single-digit return for the year,” he says.

Given his conservative outlook for the U.S. economy over the next year, Notkin likes high-yield bonds that benefit from global growth, such as technology- and commodity-sector bonds. Domestically, he likes industries in which production has fallen to such catastrophically low levels that it has nowhere to go but up. That’s leading him to bonds of homebuilders and automakers.

Still, considering the sector’s enormous run-up, investors should consider locking in gains in their junk-bond funds and taking some money off the table.

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