Some Bond Funds for Dangerous Times

Vanguard's $15 billion (VFSTX Quote)Short Term Corporate Bond Fund meets both of Berry's requirements and is one of his top choices for investors looking to maintain a diversified portfolio, but get ahead of a Fed rate hike.

In the rising interest rate environments of 1994 and 1999, Vanguard's Short Term Corporate Bond Fund was flat and up 3.3%, respectively. As of Nov. 30, the fund's one-year return is 4.99%, and its three-year average annual return is 6.10%.

The fund's portfolio manager, Bob Auwaerter, sees higher interest rates ahead but does not believe the Fed will move too quickly because of a low inflation risk.

"Inflation risk is low because there is still a lot of domestic manufacturing capacity not being used," says Auwaerter. "Asia, specifically China, also keeps inflation down because their goods keep prices down."

Aside from keeping an eye on Alan Greenspan, Auwaerter keeps an eye on expenses. The fund is no-load and has an expense ratio of 0.23% in a category that averages an expense ratio of 0.92%. This is a fact that portfolio manager Auwaerter says should not be overlooked because when "returns are so narrow, a quarter of a percent expense difference means a lot."

While Auwaerter is counting on a slow rise in rates due to lots of boats filled with low-priced Chinese imports, Bob Rodriguez is "battening down the hatches" on his ship, the $1 billion (FPNIX Quote)FPA New Income Fund.

Rodriguez has raised the liquidity level in his intermediate-term bond fund to 35%, ahead of the interest rate storm he spies on the horizon. Rodriguez has been rushing to buy short-term corporate notes from sturdy issuers such as General Electric(GE Quote) and ChevronTexaco(CVX Quote). In his wake, he has left the fund at its shortest duration ever. (Duration measures how many years it takes for the price of a bond to be repaid by its internal cash flows.)

Aside from buying very short-term corporate notes, FPA is loading up on agency bonds from Fannie Mae(FNM Quote) and Freddie Mac(FRE Quote), as well as interest-only securities, or IOS, which rise with interest rates. FPA also added nondollar denominated bonds -- French inflation index bonds denominated in euros -- to the portfolio in February 2002.

Wait a second. Isn't this a high-quality, intermediate-term corporate bond fund?

Yes, but it's an actively managed intermediate-term bond fund and Rodriguez is not afraid to act. That's especially so when he sees "absolutely no value in intermediate-term bonds right now" ahead of rising interest rates.

Rodriguez is telling clients the 10-year Treasury will range between 5.25% and 5.75% in 2004, more than 100 basis points higher than it is today.

On what does he base his predictions?

Rodriguez believes that economic growth has been better than expected and will continue to be so in the coming six to 12 months. The strong economy will increase the demand for capital and increase pressure on the Fed to raise rates.

Rodriguez's prediction: "The Fed will change policy in the early spring."

Dollar concerns also factor into Rodriguez's thinking, which explains his foray into those French inflation index bonds, which he bought when a euro cost 88 cents. Euros cost $1.21 now.

"After next year, the weakening currency will negatively affect interest rates in the United States," says Rodriguez. "International growth will pick up and current account issues will hit the U.S. dollar. Interest rates will go higher as the dollar craters."

How low can it go?

Rodriguez's prediction: "I think the euro will go over $1.35 ... in the next two years."

It's easy to argue with his predictions, but it's tough to quarrel with Rodriguez's results. FPA New Income Fund has never had a down year in the 20 years Rodriguez has been at the fund. In 1994 and 1999, the fund was up 1.4% and 3.4%, respectively. When interest rates spiked this past July, other bond funds fell while FPA rose 1.8%. Year to date the fund is up a healthy 7%.