Some Bond Funds for Dangerous Times

You don't have to be a Looney Toon to know what's going to happen when Daffy Duck says to Bugs Bunny: "When I nod my head, you hit it!"

Thwack! The mallard gets it with the mallet.

So why are bond fund investors nodding along when it's all but assured that the Federal Reserve will be hammering bond yields higher sometime soon?

Regarding bond funds, should investors be saying, "That's all, folks?"

Morningstar's Bond Fund Analyst Scott Berry doesn't believe so, although he also doesn't believe it's a great time to be piling into bond funds.

"The markets don't always react like people expect them to, which is why you may want to hold a portion of your portfolio in bond funds, for diversification purposes alone," Berry said.

Nevertheless, if the market's expectations are met, and interest rates do rise, Berry advises investors look toward shorter-term bond funds and corporate bond funds.

Berry guides fixed-income investors to the short end of the yield curve because short-term bonds are less sensitive to interest rate changes than long-term bonds.

Murphy's Law might explain it best: If you buy a bond that matures in one year, there are fewer things that can go wrong in that year than if you buy a bond that matures in 30 years, where you have a far longer stream of income at risk.

Berry's suggestion that investors steer toward corporate bonds instead of government bonds stems from the fact that government bonds yield less. The lower yield means government bonds will be more sensitive to fluctuations in interest rates. The extra yield offered by corporate bonds -- and especially high-yield corporate bonds -- cushions them (and in turn the bond funds that hold them) against principal losses when rates rise.

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