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Investors turn to U.S. junk bonds and Japan for yield

The hunt for yield in a low-interest-rate world is driving investors into markets such as U.S. junk bonds and Japanese stocks as they shrug off the risk the global recovery could stall.

Many asset managers remain upbeat about prospects for the global economy and have kept allocations to riskier assets intact despite the latest round of turmoil in Europe.

Of course, investors are hedging against possible losses. These assets have their drawbacks, including a dependence on easy money from the Federal Reserve, and they are highly vulnerable to a worsening of Europe's debt crisis.

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However, managers have been forced to become creative in their search for yield after nearly four years of zero interest rates in the United States. For now, income is trumping risk.

"Yes, there would be bumps in the road, but it helps that we have central banks in the world whose No. 1 goal is to prevent a crisis," said Sara Zervos, senior portfolio manager and global head of international fixed income at Oppenheimer Funds.

The euro zone's debt woes remain at the forefront of investor worries including the possible exit of Greece from the currency bloc after political leaders failed to reach agreement on a coalition government.

Seven Investment Management co-founder and director Justin Urquhart Stewart, however, believes euro zone leaders will somehow find a way to "manage the Greek situation." The firm's view remains that the euro will survive, although it remains to be seen whether Greece will stay in the club.

Here are a few strategies investors are using to earn income in a low-interest-rate, debt-crisis environment:

U.S. high-yield debt was a favourite among asset managers for strong returns and low volatility. Big names holding "junk" bonds included Oppenheimer Funds and Standard Life Investments.

As a backdrop, the U.S. economic outlook is generally more sanguine, defaults are low, and corporate cash is high. The market has improved in credit quality over the last two years, though partly because poorer-quality issuers have defaulted.

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The extra yield investors demand to hold the riskiest sector of the corporate bond market widened though to more than 700 basis points last week, Bank of America Merrill Lynch index data show, the widest since February.

Spreads have widened amid fears about the euro zone sovereign crisis and concerns the U.S. economic recovery was slowing down.

Richard Batty, investment director for multi-asset investing at Standard Life Investments in Edinburgh, was unfazed by the rise in high-yield spreads.

"Investing in the corporate bond market made on the basis that U.S. companies are running conservative balance sheets is still the most appropriate way to take risks," he said.

Standard, which manages assets of roughly $240-billion, has significant positions in U.S corporate bonds – both investment and speculative grade.

Volatility is also low for high-yield bonds at 6.1 per cent, based on Societe Generale's estimates, compared to 8.8 per cent for government bonds, and 21.3 per cent for equities.

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Believe it or not, investors have warmed to Japanese stocks for yield. Long shunned by investors because of deflation, low returns, and a strong yen, Japan is attracting investors, despite a ratings cut by Fitch on Tuesday.

Fitch cut Japan's sovereign credit status as a political stalemate dims the chances the country can curb its snowballing debt.

This is not the first time Japan's ratings have been cut and investors buying Japanese stocks this year could not have been oblivious to the country's problems.

EPFR data showed Japan stock funds attracted their first net inflows in March since September last year. Japanese funds saw outflows in April, but since then, inflows have resumed.

Japan's recovery from last year's earthquake and tsunami tragedy has impressed investors. As Japan's economy rebounded and the yen weakened, growth and earnings prospects, especially for the country's exporters, have improved, analysts said.

The broad Topix index has risen nearly 1 per cent this year after losses of 19 per cent in 2011 and the Nikkei index gained 3.2 per cent, after a 17.3 per cent fall.

Japan's dividend yield of 2.5 per cent is also higher than that of U.S. stocks, currently at 2.1 per cent, according to Societe Generale's estimates. Adjusted for inflation, Japan's real yield is even higher.

Seven Investment, for one, has increased its allocation to Japanese stocks in its balanced portfolio to 3.5 per cent this quarter from 1.5 per cent previously. Lyxor Asset Management in Paris, with assets of more than $100-billion, has also picked up Japan-focused exchange traded funds.

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