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What to Expect From Bond Mutual Funds in 2013

Rob Silverblatt

Where to find opportunities in the fixed-income universe

Last year was, in many ways, the year of the bond fund. As stock funds struggled with bruising redemptions, bond funds relentlessly attracted new money. Through November, investors pulled more than $122 billion out of stock mutual funds in 2012, according to the Investment Company Institute. Meanwhile, bond funds--including both taxable and municipal--saw inflows totaling nearly $300 billion.

As is often the case, however, investor behavior did not align itself with market performance. Stock investors fared quite well in 2012, with the S&P 500 finishing the year up 13.4 percent. For the most part, bond investors saw much more tepid returns. The Barclays Capital U.S. Aggregate Bond Index, for instance, registered a modest gain of less than 5 percent in 2012.

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Despite this mismatch, analysts expect that bonds will remain a popular choice among investors in 2013, in part thanks to lingering fear from the 2008 recession. "That's the sort of trend that takes [a long time] to unwind," says Jeff Tjornehoj, the head of Americas Research at Lipper, referring to investors' ongoing skepticism about trusting their retirement money to the stock market. "Once you've made a decision to be more conservative, it takes a lot of momentum in the other direction to change your mind."

For investors who remain suspicious of stocks and want to add to their fixed-income investments in 2013, Tjornehoj suggests looking for value in high-yield funds. High-yield funds had a strong 2012, with the average fund in that category gaining nearly 15 percent, according to Morningstar. Certain high-yield funds, including Loomis Sayles High Income, even returned north of 20 percent last year. Tjornehoj predicts that high-yield investments "will continue to do well."

[Read: Why Ron Baron Is Sweet on Stocks.]

Tjornehoj is also optimistic about municipal bond funds. "Municipalities have done well getting their finance under control," he says. "The bottom hasn't dropped out of the muni market, and I don't expect it to."

By contrast, the outlook for U.S. treasuries, which have traditionally been considered among the safest investments available, is less rosy.

"Be leery and recognize [that] yields in the investment-grade market--mortgages, [treasuries] and corporates--only yield 1.7 percent. It's difficult to squeeze much juice from an orange that yields 1.7 percent," mutual fund manager Bill Gross recently warned in an interview with Yahoo! Finance. Gross is the manager of PIMCO Total Return, the world's largest mutual fund.

[Read: Wisdom from Bond King Bill Gross.]

Another issue for bond investors to keep an eye on in 2013 is interest rates. As interest rates rise, bond prices fall. Bond funds with longer average durations stand to suffer the most from rising rates.

Roger Young, the senior vice president of fixed income at Fidelity, acknowledged in a recent bond outlook that the prospect of rising rates means that "this does not seem like a great time to move into bonds opportunistically."

Nonetheless, he cautioned against panic. "Rising interest rates are not what bond investors would prefer," he observed. "But if history is any guide, there will be a slow move up, and what is lost in price will be at least partly made up in rising income."

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