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Mutual Fund Investors Fell In Love With Bonds In 2010

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BOSTON — Mutual fund investors were buying stock funds at the end of 2010. But they were trying to avoid risk through most of the year, as bond funds took in money at the second-fastest annual rate ever.

A tally Wednesday by industry consultant Strategic Insight shows investors added $222 billion more to bond funds than they withdrew. The record for money flowing into bond funds came in 2009, when investors added a net $350 billion. That followed a year when stocks suffered their worst decline since the Great Depression.

Investors responded by seeking the relative safety of bonds. But with the economic recovery gaining momentum, fear of rising interest rates has recently cut into bond returns. Two-thirds of the bond fund categories tracked by Lipper Inc. suffered losses in the fourth quarter, as rate fears sent bond prices down and yields up.

Investors typically sell off when prices fall, and December was no exception. Investors pulled a net $24 billion from bond funds last month, according to Strategic Insight. It was the biggest monthly movement out of bond funds since the peak of the financial crisis in October 2008. It was also the second consecutive month that more money was pulled out of bond funds than came in. About $1 billion exited in November.

But Strategic Insight isn't ready to declare that investors are ready to give up on bonds. Research Director Avi Nachmany said his New York-based company still expects demand to rebound in the first half of this year. That's because many categories of bonds offer attractive yields compared with those of bank accounts and money-market funds, which are near record lows.

"For some, the focus on income and risk aversion will persist through 2011," Nachmany said.

Many bond investors nevertheless embraced risk last month. Flows were positive for high-yield funds, which hold bonds that typically earn high rates of return, with greater risk of volatility. Those funds returned an average 3.5 percent last quarter, according to Lipper.

That compares with an 11.4 percent fourth-quarter gain for the average U.S. stock fund.

With such strong returns, flows into stock funds have recently begun to shift. For the full year, investors added a net $23 billion into stock funds.

Yet despite an average 17 percent return last year for the average U.S. stock fund, they weren't attracting money. They saw nearly $49 billion flow out. The overall flow of money was positive for stock funds because investors were putting their money in foreign stock funds, which drew in a net $72 billion.

There's been a flow of money into foreign stock funds for seven straight months. This reflects the stronger economic growth prospects many investors see in the world's emerging markets, and a desire to diversify portfolios beyond U.S. financial markets.

Still, there are signs that U.S. investors are warming up to domestic stocks. Through most of 2010, the rate at which cash was pulled out of U.S. stock funds slowed. For one week in late December, flows into U.S. stock funds even turned positive, according to the Investment Company Institute, an industry association.

"It is clear that stock investor sentiment is slowly improving," Nachmany said.

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