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Hedge Funds Look to Play High-Yield Bonds, US Stocks

Date: Friday, May 10, 2013
Author: Paul Toscano, CNBC

Top hedge funds are playing into global trends and have identified U.S. stocks and inflation assets as key areas where markets are mispricing risk-reward.

Two top hedge fund managers told CNBC where they are putting money now and where they expect money will move for the rest of the year.

With many in the market predicting a "great rotation" out of bonds and into stocks, Jeffrey Kronthal, co-CIO at KLS Diversified Asset Management, said that his firm hasn't seen the move, instead, there has been a rotation out of cash and into risk assets.

"We've been a big believer that high yield has been cheap throughout most of the year," he said. However, Kronthal sees that these assets have reached fair value, compared with expected default rates and risk-adjusted returns.

"We continue to think that default rates will be very, very low," he added.

However, John Burbank, CIO of Passport Capital, sees better opportunity in global equities. "The big trend is to get yield however you can do it, and equities often now offer you better yield with growth than bonds," he said. "Equities are now a better risk-reward than they were before."

Burbank sees a trend toward defensive stocks that is "not normal" and expects that although global growth will be slow, a "big trend" to dividend stocks will continue for at least the next three years.

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"The world is not going to become more liquid. The liquidity that is being issued by central banks is going into yield products, into safe things, into bonds," he said. "It's not going into big investments in infrastructure, it's not causing a lot of new growth. In fact, it's moving in the opposite direction."

Kronthal also expects sluggish global growth, pointing out that with dramatic moves by central banks, the monetary base has not been growing in step.

"A lot of this money is going towards consumption and the savings rate of consumers is going down. So some of the wealth effect is really showing up with consumers spending some of that out of their current incomes," he said.

"I'm not a believer that we're going to get a lot of inflation," he said, and in this environment one of his favorite trades is to short TIPS, government securities that track inflation, because he believes the market is currently overpaying for inflation protection.

"The world thinks inflation is coming and people are paying over fair value for that protection," Kronthal explained.

(Related: Hedge Fund Billionaire Paulson Glosses Over His Losses)

In an inflationary environment where governments aren't supporting growth, Burbank suggests owning U.S. companies that are world leaders because these are likely to have growth, liquidity, top governance, dividends and good capital allocation.

"U.S. companies are increasingly spreading around the world but they don't need the whole world to grow," he said.

"The irony with the S&P is that if there is wage inflation, then profit margins shrink and profit margins are going to fall, so that's a big question," Burbank said. "Their growth, increasingly, is harvesting richer consumers from around the world. I like the general prospects of world-class companies, I just don't like the prospects of average companies."

"The money is going to high-quality assets around the world," he added.

óBy CNBC's Paul Toscano. Follow him on Twitter and get the latest stories from "Squawk on the Street" @ToscanoPaul