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Winter winds hitting bond investors, China takes a pass, alternatives posted strong gains: Morningstar data

But fund categories that bond investors tend to favor when 'reaching for yield' were up nicely in December

Wednesday, January 26, 2011 – 3:56 PM by Rob Isbitts, Columnist
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Rob Isbitts: Convertibles, Long-Short, High Yield Bond had strong gains relative to risk.

A monthly review of financial market performance and trends, as told through mutual fund category performance (data supplied by Morningstar).

Too much focus on past returns and not enough on analyzing potential risk can lead you to classic investment mistakes. In December, few cared about risk in the U.S. Equity market. The S&P finished off a strong four-month rally, rising 6.68%. That monthly return was exceeded by only 20 of the 84 fund categories I follow. As with any month, that one index is only the headline. Now, as Paul Harvey used to say, here’s the rest of the story …

• Financial stocks were the top category in December (+9.58%), and the next four in order were Foreign Small-Mid Value (+9.43%), Natural Resources (+9.35%), Commodities-Broad Basket (+8.99%), and Foreign Small-Mid Growth (+8.84%). Rallies in Europe funds (+8.45%) and Japan (+7.84%) helped make this happen.

• Emerging Market funds (+6.12%) joined the early New Year’s Eve party, but for a change China (+1.24%) was largely absent.

• Some of the key “Alternative” categories (according to my classification system, used for over a decade) participated as you would expect. Specifically, Long-Short (+3.05%), High Yield Bond (+1.98%), and Convertibles (+4.55%) all posted strong gains relative to their general risk levels, but lagged the strong up month. Would it upset anyone if I said that “Convertibles” reminds me that I saw someone driving around my South Florida neighborhood in early January with his convertible car’s top down? OK, I’d better change the subject, since most of you don’t have that kind of winter weather …

• The snow and strong winds of winter are symbolic for what many bond investors are starting to experience. The difference is, the bond investors may not have expected their weather to turn for the worst. In December, Long Government funds lost 3.26%, as the interest rate on the 10-year and 30-year U.S. Treasury Notes both rose. The 10-year moved from about 3.0% to 3.5% during the first half of December, and the 30-year ran up from below 4.1% to peak for the month at over 4.6% before falling back a bit by year-end.

• This should give you a pretty good idea of what the downside is in U.S. Government Bond prices, should rates continue higher anytime soon. The potential for rate increases of 2-3% over this calendar year does not appear to be staring us in the face, but if something of that magnitude did occur, it would be a greater shock to investors than nearly anything stocks have ever “done to them.” Finally in this area, Inflation-Protected Bonds, which are primarily U.S. Government issues, rose 1.35%.

• One reason for my caution on the downside of bonds is that the fund categories that bond investors tend to favor when “reaching for yield” we up nicely in December. Retirement Income funds (+1.46%), Emerging Markets Bond funds (+1.05%) and Multi-Sector Bond funds (+.0.83%).
I welcome your questions and feedback at risbitts@cwm-llc.com.

Robert A. Isbitts, a 25-year industry veteran, is a newsletter writer, published author, and investment strategist. He is also the lead-manager of asset allocation mutual fund and a global equity mutual fund. For more information on those mutual funds, visit www.easfunds.com. His second book, “The Flexible Investing Playbook” – Asset Allocation Strategies for Long-Term Success” was published by John Wiley & Sons in August, 2010.

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