With rate hikes looming, bond investing is no picnic. Our picks will protect your assets. Thinkstock By Nellie S. Huang, Senior Associate Editor From Kiplinger's Personal Finance, March 2015 Yields on Treasuries and other high-quality debt fell in 2014 and prices rose, marking the fourth straight year that investors had braced for rising interest rates only to be confounded by a fickle bond market. Could 2015 be a repeat of 2014? Most observers expect the Federal Reserve to raise short-term rates, probably in the second half of the year.See Also: Hedge Risks With Overseas Bond Funds But not so fast. A strong dollar is attracting foreign investors and propping up bond prices (which move in the opposite direction of yields). And though the U.S. economy grew by a stunning 5% in the third quarter of 2014, wage growth remains tepid. Plus, plunging oil prices should help keep inflation, the biggest enemy of bond investors, at bay. Take all these factors together, and you do not have a recipe for rising rates, says Jeffrey Gundlach, CEO and chief investment officer of DoubleLine Capital, which specializes in bonds. Still, the better the economic news, the more likely the Fed will hike short-term rates, which have been near 0% since late 2008. “The Fed would like to move away from its zero-rate policy sooner than the market expects,” says Dan Heckman, a fixed-income strategist with U.S. Bank Wealth Management in Kansas City, Mo. But any Fed hikes will be “baby steps” of 0.25 percentage point at a time, he says. Advertisement If Heckman is right, other short-term rates will most likely move up in step, including those on savings accounts and short-term certificates of deposit. But rates on intermediate-term and long-term bonds may edge up only slightly, if at all. “We’ll see less impact on the 10-year Treasury if short-term rates rise than on the two- or three-year note,” says Roger Early, a bond strategist at Delaware Investments. So what can you do to protect your bond portfolio? Build a mix that straddles the fence between the odd chance that rates will stay lower longer than the world anticipates and the possibility that rates will rise, albeit slowly. Shortening maturities, the traditional strategy for coping with rising rates, may not be the best move this time around. And a strategy of investing in high-yield “junk” bonds, which usually hold up well when rates climb, may not work this year given the woes of the energy sector. We suggest you start with an intermediate-term bond fund, then fortify your position with funds that offer some protection against higher rates: flexible funds and those that invest in floating-rate loans. If you’re in a high tax bracket, municipal bond funds, which pay interest that is free of federal income taxes and which offer generous yields on an after-tax basis, are a solid bet. A well-crafted mix will earn you a good yield and provide some defense against interest-rate uncertainty. Intermediate-term bonds In almost all markets, a diversified, medium-maturity fund should be at the core of your bond portfolio. Fidelity Total Bond (symbol FTBFX, 2.9% yield) holds corporate debt (including a smattering of junk issues), bank loans, mortgage-backed securities and some foreign bonds that are hedged against further strengthening of the dollar. The fund’s four managers focus on understanding the big picture—for instance, the outlook for the economy and interest rates—as much as they do on choosing the right securities. London-based comanager Michael Foggin, who came on board last October, has been tapped to identify attractive corporate bonds in Europe and Asia. Over the past 10 years, Total Bond, a member of the Kiplinger 25, returned 5.1% annualized, beating its benchmark, the Barclays U.S. Aggregate Bond index, by an average of 0.4 percentage point per year. The fund’s average duration is 5 years, suggesting that its price would decline by roughly 5% if rates on intermediate-maturity bonds were to rise by one percentage point. (All returns are through December 31.) Advertisement DoubleLine Total Return Bond (DLTNX, 3.7%), which specializes in mortgage-backed securities, isn’t as diversified as the Fidelity fund, but its unusual strategy has consistently delivered good returns. Gundlach, the fund’s lead manager, employs a “barbell” strategy: He balances government agency bonds, which carry no default risk but a lot of interest-rate risk, with non-agency mortgage-backed bonds, which have little interest-rate risk but a lot of default risk. The result is a fund that delivered an annualized 5.0% return over the past three years, beating the typical taxable, intermediate-maturity fund by 1.5 percentage points per year while being 10% less volatile than its average peer. Its average duration is 3 years. Gundlach hinted recently that there is a greater than 50% chance that the fund, a member of the Kiplinger 25, will close to new investors in 2015. Floating-rate loans Rising rates are bad news for holders of most kinds of bonds, but not for investors in floating-rate bank loans. That’s because rates on these loans are tied to a short-term benchmark and reset every 30 to 90 days. The downside is that the borrowers are generally companies with below-investment-grade credit ratings. That’s why we like funds that focus on loans on the higher end of the sub-investment-grade scale. Our favorite bank-loan fund is Fidelity Floating Rate High Income (FFRHX, 4.3%). Its average duration is just 0.3 year. Manager Eric Mollenhauer has nearly half of the fund’s assets invested in loans made to companies rated double-B (the highest non-investment-grade rating). He prefers to invest in loans made to large companies that generate plenty of cash flow and that are backed by assets you can see and touch. One top holding: loans made to HCA, the country’s largest for-profit hospital company. “We can’t live without hospitals,” says Mollenhauer. “HCA is churning out cash, has a good management team and has high market share in many key markets.” He says he expects the sector to post returns of 5% to 6% this year. Because of the fund’s conservative approach, it typically isn’t near the top of the pack in any given year. Over the past three years, Floating Rate High Income returned 3.7% annualized, trailing the average bank-loan fund by an average of 1.5 percentage points per year. But the Fidelity fund has been 7% less volatile than its peers during the period and has excelled during troubling times. For example, in the midst of the financial crisis in 2008, the average bank-loan fund lost 29.7%, while the Fidelity fund surrendered 16.5%. Mollenhauer wasn’t in charge then (he came on board in 2013), but he says he employs the same strategy as his predecessor. Advertisement Go-anywhere funds Funds that can reach into any pocket of the bond market (and even bet against it) offer another way of coping with uncertainty and elevated risk. The four managers of Metropolitan West Unconstrained Bond (MWCRX, 1.6%) can do just that. Lately, the foursome—Steve Kane, Laird Landmann, Tad Rivelle and Bryan Whalen—have focused on widely traded, high-quality debt in specific sectors, such as non-government-agency mortgage securities and commercial mortgage bonds. The fund, a member of the Kip 25, hews to no benchmark. But over the past three years, it earned 7.2% annualized, an average of 4.5 percentage points per year better than the Barclays U.S. Aggregate Bond index. Average duration: 1.2 years. With the sudden departure of founder Bill Gross, bond giant Pimco suffered from the glare of a lot of negative publicity last year. But the firm retains plenty of talented investors, including Daniel Ivascyn, Pimco’s new chief investment officer. He and Alfred Murata run Pimco Income (PONDX, 3.8%), which generated a robust 11.7% annualized return over the past five years, clobbering the Aggregate Bond index by 7.2 percentage points a year. The portfolio, which has an average duration of 2.5 years, is divided into two parts. One part holds higher-yielding securities—such as non-agency mortgage-backed securities, bank loans and corporate IOUs (both investment-grade and junk)—that the managers think will do well if the economy does better than expected. The other part holds high-quality assets, such as Treasuries and government-agency mortgage securities, to protect the portfolio if the economy does worse than expected. It’s a good strategy for uncertain times. Municipal bonds No matter what you invest in—stocks, real estate or even bonds—one way to play defense is to buy bargains. One area of the bond market that looks especially cheap today is municipal bonds. In early January, 10-year, triple-A-rated munis yielded an average of 1.9%. Because interest from munis is exempt from federal income tax (and sometimes from state and local income taxes, too), a 1.9% tax-free yield is equivalent to a taxable payout of 3.4% for someone in the highest federal tax bracket. That’s not bad, considering that 10-year Treasuries yield just 2.0%. Mark Sommer, manager of Fidelity Intermediate Municipal Income (FLTMX, 1.4%), our favorite muni fund and a member of the Kiplinger 25, says that tax-free bonds aren’t immune to shocks in a rising-rate environment. But the tax benefits and the current “low supply” of new issues, says Sommer, mean “the market will be well supported” when rates rise. His fund’s average duration is 4.7 years. How will your fund fare if rates rise? Interest rates and bond prices move in opposite directions, so when rates rise, the value of a bond will fall. But that doesn’t mean you always lose money. If you buy individual bonds and hold them to maturity, for example, interim rate moves won’t matter. When the bond matures, you’ll get your principal back—assuming, of course, that the issuer doesn’t default. Advertisement Bond funds, however, are a different matter. Their managers buy and sell bonds continually and may or may not hold issues until they mature. So prices of bond funds change daily, and when you sell, you may get a lower price than you paid. To get a sense of how your bond fund will perform when rates rise, look at its average duration, a measure of interest-rate sensitivity. A fund with, say, an average duration of 3 years would likely suffer a 3% drop in net asset value if rates were to rise by one percentage point. But over time, the interest a fund pays you will offset some, if not all, of the decline in NAV. Consider, for example, DoubleLine Total Return (DLTNX), with a yield of 3.7% and an average duration of 3 years. If rates rise by one percentage point, the fund would likely deliver a small positive total return. Junk in a funk Why don’t we have a high-yield fund on our list of moves to make this year? After a sluggish 2014, the average yield of junk-rated corporate bonds has climbed to 6.7%, outstripping the yield of the average investment-grade corporate bond by three and a half percentage points. Moreover, the growing strength of the U.S. economy redounds to the benefit of junk issuers, decreasing the chance that they’ll default on their debt obligations. The problem is the energy sector: Debt issued by energy companies makes up 13% of the Bank of America Merrill Lynch U.S. High Yield Master II index, and the 55% drop in oil prices puts the weaker players of the sector in potential peril. Until those prices stabilize, we’re in a wait-and-see period for high-yield bonds, says Christopher Dillon, a global fixed-income analyst at T. Rowe Price.