Mutual funds that buy bank loans turned in the smallest gains of any fixed-income group in 2007 after subprime-mortgage losses scared off...

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Mutual funds that buy bank loans turned in the smallest gains of any fixed-income group in 2007 after subprime-mortgage losses scared off high-yield debt investors.

Loan funds managed by firms including Eaton Vance and Hartford Investment Management returned 1.1 percent last year, according to data from Chicago-based Morningstar.

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 subprime 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 leveraged-buyout 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’s 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.

“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, Calif.-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 subprime 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 JPMorgan Chase & Co.

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.

“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 Great-West Lifeco, of Winnipeg, Canada, manages $67 billion in fixed-income assets. Its $515 million Floating Rate Income Fund rose 1.9 percent in 2007.

Private-equity firms such as Blackstone Group and Oaktree Capital Management of Los Angeles have raised funds to purchase loans stuck on banks’ balance sheets.