Warming economic data, a belief the U.S. would avoid the fiscal cliff and a search for yield drove outperformance by emerging markets debt funds -- especially the local currency variety -- and high-yield bond funds in December, the fourth quarter and 2012.
In Q4 emerging markets funds soared 3.60% on average, on top of a 1.38% gain last month, according to preliminary Lipper Inc. data. Their 2012 jump was 18.46%.
Local currency emerging markets debt funds skyrocketed 3.86%, with a 2.19% December finish. Junk-bond funds climbed 3.05% on a 1.47% gain last month.
"Despite the fact that the economy is struggling, it is improving," said Joe Balestrino, manager of eight Federated Investors funds, including $7.6 billion Total Return Bond . "And the search for yield is something we've seen all year."
The big laggards were GNMA and general U.S. government funds. GNMA funds lost 0.33% in Q4 despite edging up 0.09% last month. General U.S. government funds slipped 0.34% in Q4 after giving back 0.42% last month alone.
Treasury funds gave back 0.37% in Q4 after plunging 0.86% last month. They gained 2.24% in '12. Treasuries rallied late in December on investor fears of the fiscal cliff.
Mortgage-related government debt got hit by investor concerns that mortgage-backed securities had grown too pricey.
Investors also worried that the Obama administration might seek a loan-principal forgiveness program to ease mortgage foreclosures.
Balestrino expects shaky performance in Q1. A temporary fiscal-cliff compromise won't relieve all investor anxieties, he said.
After that, he sees a repeat of the second half of 2012, maybe better. "We'll get back to trading on fundamentals," he said.
He bought a 30-year Treasury in August. At the start of Q4 its price was 98.50, yielding 2.82%. Its price bottomed at 95.25, yielding 2.99% on Dec. 18. Late-December fiscal-cliff fears drove investors back, lifting its price to 96.22, yielding 2.94%, for a -1.63% Q4 total return.
Tax-exempts had a decent 2012, gaining 7.14% on average. That was despite losing 1.34% on average in December and barely breaking even, up 0.63%, in Q4.
The December sell-off occurred as investors decided munis had rallied as much as they should vs. Treasuries, said Phil Condon, DWS Investments' fixed-income chief strategist and head of its muni bonds.
Still, he owned a muni that topped comparable Treasuries in Q4. His was a Broward County, Fla., airport bond rated A+ by S&P with a 5% coupon, due 2037 with a 2022 call, with a 1.8% Q4 total return. The Barclays U.S. Long Government Index lost 1.01%.
Also, after the November elections, many investors decided to take profits. Debate still raged about who would be hit with higher taxes on bond interest and whether munis' tax exemption would be cut or stopped.
Condon remains bullish on munis. The yield on 10-year AAA munis is 1.8% vs. 1.83% on a 10-year Treasury. "That gives munis the edge on an after-tax basis," he said.
Condon warns that many investors could rotate back to equities in 2013. "That's more of a threat to Treasuries than munis," he said.
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