The Best Bond Fund Strategy Now

These are trying times for bond fund investors. Those long-term bond yields that had remained stubbornly low even as the Federal Reserve Board repeatedly raised short-term rates are finally trending upward. Since last winter, the yield of the benchmark ten-year Treasury note has climbed from 4.3% to 5.1%. And because bond prices move inversely with yields, bond fund investors are experiencing the unusual sensation that comes from seeing their holdings actually lose money. Year-to-date, the Lehman U.S. Aggregate Bond index, the broadest measure of the taxable U.S. bond market, has returned 0.6% (a figure that includes interest income as well price declines). Two of our favorite bond funds are treading water. Dodge Cox Income (symbol DODIX) is flat for the year, and Harbor Bond (HABDX) is down 0.4%.

If you feel the impulse to bail out of your bond funds, think twice. For starters, few mortals can time the bond market. Moreover, inflation, which is probably the biggest determinant of interest rates, at least over the long term, remains reasonably well behaved, despite the run-up in energy prices. That suggests that we're certainly not heading back to a period of double-digit interest rates -- or even high single-digit interest rates.

The simplest way to deal with rising rates is to do nothing at all, especially if you are investing for the long haul. "Investors need to find the level of stocks and bonds that works for them in terms of risk and stay with that mix without changing it a whole lot," says Ken Volpert, a senior bond manager at Vanguard.

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If you're worried that rates will continue to rise, stick with short-term bond funds. Short-term bonds are less volatile than long-term bonds -- that is, their prices move less with changes in interest rates -- and thus generally hold up better in rising rate environments. Short-term bond funds are especially attractive for investors with time a horizon of five years or less. "This year, investors have been rewarded for staying short," says John Hyll, a fixed income portfolio manager at Loomis Sayles Co.

But steer clear of emerging-market and other high-yield bond funds for now. They have experienced impressive gains over the past few years. But investors "aren't being compensated well enough for the risks they're taking," says Wayne Wicker, chief investment officer for ICMA-RC, which manages retirement plans for public employees. Wicker prefers Treasuries and high-quality corporate bonds.

--Thomas M. Anderson