Despite their recent dip, interest rates are still likely to rise and put many bond funds at risk. By Jeffrey R. Kosnett, Senior Editor April 1, 2011 A few weeks ago I identified 11 bond funds that I said would hold up in an environment of rising interest rates. I wrote the column out of a conviction that the three-decade-long bull market in bonds, which had seen bond prices rise steadily as yields on ten-year Treasuries plummeted from 15.7% to nearly 2%, was finally over. No boom goes on forever, and this one lasted far longer than anyone could have imagined. At first glance, it seems my call may have been premature. With the U.S. economy emitting mixed signals about growth, jobs, consumer confidence and inflation, the bond bears have quit growling. Concerns that the disaster in Japan would suppress growth there and elsewhere have also quieted the bears. As a result, interest rates have receded and bond prices have been climbing lately. After reaching 3.7% in early February, the yield on the ten-year Treasury fell to 3.3% as of March 15, before rebounding to a bit less than 3.5% on March 30. It is indeed tempting to suggest that Japan’s troubles and a tepid U.S. economy will intervene to keep interest rates down for a while. But when I get past the headlines and consider the rest of the economic and financial news, I revert to my initial view: The economy is getting better, and interest rates are more likely to rise than to fall from current levels. My advice, in three words: Think safety first. Here’s how: Avoid bond funds with long durations. Advertisement A bond’s duration indicates how much the bond is likely to lose in value if interest rates rise one percentage point (or gain in value if rates fall one point). Bond funds report average duration on their Web sites; you can also find the figure at Morningstar.com. Because funds that invest in longer-term bonds normally yield more than those that buy shorter-term bonds, you might be interested in a fund such as Vanguard Long-Term Treasury (symbol VUSTX). The average maturity of the fund’s holdings is 19.4 years, and the fund yields 3.5%. That compares with the 1.8% yield of the Vanguard Intermediate-Term Treasury Fund (VFITX). The trouble is this: When bond yields are low, the potential damage to your principal from rising rates is magnified. Currently, Vanguard Long-Term Treasury has an average duration of 12.7 years, so you could expect to lose 12.7 cents on every dollar if interest rates on the kinds of bonds the fund invests in were to bump up one percentage point. In fact, we’ve seen this kind of action recently: The yield on ten-year Treasuries rose from 2.5% on October 5 to 3.7% on February 4, and Vanguard Long-Term Treasury lost 10% (that’s a total return figure and includes income). Over that period, the fund suffered one-day drops of 1% or more on 19 occasions. Interest rates are unlikely to surge while nuclear-reactor fires still rage. But once the cleanup gets under way and Japan’s economy restarts, rates are likely to rise. (Another shove in that direction will be when the Federal Reserve ends “quantitative easing,” its program of goosing the economy by buying massive amounts of Treasury bonds.) Advertisement At that point, you don’t want to be anywhere near a long-term Treasury fund. Vanguard Total Bond Market Index Fund (VBMFX) and its exchange-traded clone, Vanguard Total Bond Market ETF (BND), with yields of 2.8% and 2.9%, respectively, and average durations of five years, are better choices. Better still is Dodge & Cox Income (DODIX), a fund that invests mostly in high-grade corporate bonds, yields 3.8% and has an average duration of four years. Plus, its annual expense ratio of 0.43% is about as low as you can get from an outfit not named Vanguard, the low-cost leader. Don’t expect fund managers to be magicians. Just because a bond fund has a fabulous long-term record doesn’t mean its managers can protect your money when the tide goes out. With a few exceptions, bond funds are just not set up that way. Most funds are designed to invest in bonds of specific maturities -- long-term, intermediate-term or short-term -- and in specific sectors of the bond market (for example, Treasuries, mortgage securities, foreign bonds and so on). The most brilliant bond pickers -- and they are rare -- are handcuffed in adverse markets because no bond’s value can defy rising rates or inflation for long. A fund’s bylaws usually ban sharp cuts in duration or hoarding cash. So a fund’s performance will suffer, and when too many people sell -- a big problem lately for municipal-bond funds and one that will likely afflict high-yield corporate bond funds once the two-year-long rally in junk bonds ends -- managers must unload bonds to raise money for redemptions. That leaves the fund short of money to buy new bonds issued with higher yields. Advertisement What now? Ginnies and munis. Surprised? Aren’t Ginnie Maes involved in mortgages, and aren’t mortgage investments still dangerous? Not Ginnies. The full faith and credit of the U.S. Treasury guarantees mortgage securities backed by the Government National Mortgage Association. So the big risk with owning GNMA funds is soaring interest rates. But GNMA securities pay more than Treasuries, making them a bit less sensitive to rising rates. A good choice is Vanguard GNMA (VFIIX). It yields 3.1% and has an average duration of 3.6 years. As for municipal bonds, the panic that drove down fund prices and emptied many of the funds of assets over the past three months has dissipated. Stay with muni bonds if they make sense for you tax-wise; just avoid funds that focus on high-yield, or junk, munis. A sound pick is Fidelity Intermediate Municipal Income (FLTMX), a member of the Kiplinger 25. It yields a tax-free 3.0% (equivalent to 4.6% for an investor in the top federal bracket of 35%) and has an average duration of 5.4 years. I’ll discuss tax-exempt funds of all kinds -- single-state, national and ETFs -- in detail in the near future.