Bonds Can Corral Your Risk

"Bonds are often boring, but boring is not necessarily a bad thing," says Joyce. "In fact, sometimes it's the smartest way to invest."

The one risk to bonds that may eliminate some of that boredom is rising interest rates, which would drive down bond prices. The threat of inflation and its resulting effect on interest rates is causing many financial advisers to shorten the maturities of the securities they buy for their investors. Interest rate swings have less of an impact on short-term bond prices compared with longer maturity bonds because there is less risk to the income stream.

Diane Pearson, a financial adviser at Pittsburgh-based Legend Financial Advisors, suggests bank loan funds as a way to maintain a fixed-income allocation while still guarding against a rise in interest rates.

Bank loan funds invest in loans packaged and issued by banks and other financial institutions, mostly to distressed companies. Unlike the typical bond fund, however, which primarily invests in bonds with fixed rates, the securities held in bank loan funds are variable rate ones, which means they change every few months. Therefore, the rates on the loans held in a bank loan fund will rise along with interest rates. In turn, the yield on the fund rises as well.

Pearson says she uses the (XLFAX Quote)Highland Floating Rate fund for her clients. Other notable funds that employ this strategy include the (NFRCX Quote)Sun America Senior Floating Rate fund, (EVBLX Quote)Eaton Vance Floating Rate fund, (FFRIX Quote)Fidelity Advisor Floating Rate fund and the (FAFRX Quote)Franklin Floating Rate Daily Access fund.

Another strategy for investors seeking simplicity is to invest in a single fund that makes all the decisions regarding asset allocation for them according to their risk tolerance. Gartmore funds, for example, has recently rolled out four Optimal Allocations Funds, which are broadly diversified, professionally managed, risk-based funds that are automatically rebalanced quarterly. The fund comprises a suite of other Gartmore funds.