NEW YORK (Bloomberg) -- Mutual funds that buy bank loans turned in the smallest gains of any fixed-income group in 2007 after sub-prime-mortgage losses scared off high-yield debt investors.

Loan funds managed by firms including Eaton Vance Corp. and Hartford Investment Management Co. returned 1.1 percent last year, according to data from Chicago-based Morningstar Inc. U.S. Treasury funds that protect against inflation rose 10 percent, the most in Morningstar's fixed-income group.
Bank-debt funds, which hold low-rated loans that are often used to finance leveraged buyouts, fell as the sub-prime collapse in July sent investors fleeing from all but the safest government bonds. Concern that corporate defaults would increase as the U.S. economy slowed also reduced demand, leaving banks with $350 billion of LBO debt that they had committed to sell.
“Loan funds got hit square in the face with the contagion,” said Payson Swaffield, chief investment officer for fixed income at Boston-based Eaton Vance, who oversees $53 billion, including $20 billion in bank-loan assets.
Leveraged loans lost as much as 4 percent in July, the worst month ever, according to Swaffield. The $1.2 billion Eaton Vance Floating Rate & High Income Fund returned 1.7 percent last year, according to data compiled by Bloomberg.
------------------- ‘Technical imbalance’
“There has been the largest technical imbalance that we've seen in the market” with a “significant overhang of unsold loans that Wall Street was holding,” Swaffield said.
Individual investors withdrew money from loan funds for 23 of the 24 weeks in the period ended Dec. 26, pulling a total of $4.5 billion, according to analysts at Arcata, California-based AMG Data Services.
Loan funds returned 5.7 percent on average over the past five years, better than seven of 12 other fixed-income fund categories tracked by Morningstar.
Losses on sub-prime mortgages closed the market for collateralized debt obligations, which had been the biggest buyers of leverage loans. Global issuance of CDOs fell to $141 billion in the second half of last year from $334 billion in the first half, according to a Dec. 17 report by New York-based JPMorgan Chase & Co., the third-biggest U.S. bank.
Collateralized loan obligations, which buy loans and repackage them into new securities, bought almost two-thirds of leveraged buyout debt in the first half of 2007, according to Standard & Poor's Leveraged Commentary & Data unit. CLO managers accounted for about 21 percent of loan purchases in the second half through November, S&P data show.
------------------------------Leverage squeezed out
“You had one of the biggest constituents in the bank loan market, CLOs, basically step out of the market starting in July,” said Paul Scanlon, team leader for U.S. high yield and bank loans at Putnam Investments in Boston.
Putnam, a unit of Winnipeg-based Great-West Lifeco Inc., manages $67 billion in fixed-income assets. Its $515 million Floating Rate Income Fund rose 1.9 percent in 2007.
“There's some concern about credit fundamentals and there was a lot of borrowed money that was driving the purchase of bank loans,” Scanlon said. “There was a lot of leverage that got squeezed out of the system.”
Loan investments may perform better this year, Scanlon said. The market's poor performance has left “some nice opportunities” as banks sell LBO debt at 94 cents to 95 cents on the dollar, Scanlon said. Private-equity firms such as New York- based Blackstone Group LP and Oaktree Capital Management LLC of Los Angeles have raised funds to purchase loans stuck on banks' balance sheets.
-----------------------Spreads widen
High yield, or junk, debt is rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's.
The extra yield, or spread, investors demand for loans rated B widened to 4.28 percentage points above the three-month London interbank offered rate from 2.13 percentage points in February, according to S&P. Libor, a lending benchmark that fluctuates depending on how willing banks are to lend to each other, is 4.62 percent.
Junk-bond mutual funds returned 1.5 percent on average last year, the second worst category among fixed-income funds, Morningstar data show.
Risk premiums on bank debt were relatively narrower than those on junk bonds before the market seized up because investors used more leverage, or borrowed money, to invest in the loans, buoying demand, said Martin Fridson, chief executive officer of high-yield research firm FridsonVision LLC in New York.
“There was more leverage in them so the problems affected the loans more than the bonds,” Fridson said. “By definition, if no one was buying them without leveraging them up, that's something that's bound to come unwound sooner or later.”