2011 Midyear Investing Outlook: What Now for Bonds?

Consider bond funds run by seasoned pros to navigate this tricky fixed-income environment.

This is a tricky time for fixed-income investors. Consider the ten-year Treasury bond, which currently yields 3.2%. If you own a ten-year Treasury and yields increase to 4% by year-end (far from a heroic assumption), your bond will lose about 7% of its value.

Because of the Fed's extraordinary efforts to keep interest rates low, high-quality bonds are not adequately compensating investors for heightened inflation risk and the chance that these IOUs may lose a significant amount of value if rates rise. If you do buy Treasuries, government-agency bonds and high-grade corporate debt, keep maturities short and plan to plow interest and maturing principal back into bonds with higher yields as rates rise.

See the rest of our 2011 midyear investing outlook: Stocks and the Economy Face Off.

In theory, you could benefit by substituting credit risk for interest-rate risk at this stage of the economic cycle. After all, defaults on high-yield, or junk, bonds are running at a remarkably low annual rate of 1% as the economy strengthens. But junk bonds have had an enormous run since March 2009 and appear to be fully valued.

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Still, in this environment, you may want to be a bit more adventurous and consider bond funds run by seasoned pros who have the flexibility to roam far and wide, and certainly outside the confines of the investment-grade space. For instance, Dan Fuss and Kathleen Gaffney, of Loomis Sayles Bond (LSBRX) -- a member of the Kiplinger 25, a list of our favorite funds -- are finding value in higher-grade junk and bonds of commodity-exporting nations such as Norway and Australia. This volatile fund yields 4.2%.

For something with a similar yield but 60% less volatility, consider Osterweis Strategic Income (OSTIX). Managers Carl Kaufman and Simon Lee invest mainly in convertible and short-maturity, high-yield bonds. Jeffrey Gundlach's DoubleLine Total Return Fund (DLTNX) offers an 8% yield and low volatility. DoubleLine, also a member of the Kiplinger 25, holds both high-quality and low-grade mortgage securities.

A different strategy is to invest in foreign bonds, particularly those from emerging markets whose financial health is improving and whose currencies are rising against the dollar. A worthy choice with a solid record is Pimco Emerging Local Bond Fund D (PLBDX), managed by Mike Gomez.

See the rest of our 2011 midyear investing outlook: Stocks and the Economy Face Off.

Contributing Writer, Kiplinger's Personal Finance