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Bond Mutual Funds That Escape Bear Markets

NEW YORK ( TheStreet) -- The rally in bonds, like the bull market in stocks, may be slowing.

High-yield bond funds returned 32% in the past year, and intermediate-term bond funds gained 14%, according to Morningstar. Many bonds now have high prices and low yields, which could be reversed if interest rates rise in the next year, as many economists predict.

Should you avoid bond funds altogether? Probably not. Most portfolios should have fixed income for diversification. Consider putting part of your fixed-income holdings into flexible funds. These have the ability to emphasize Treasuries one year and corporate bonds the next. By trading deftly, top flexible funds limit losses in hard times. In contrast, typical bond funds hold relatively static portfolios that can be hurt when interest rates rise.

A compelling flexible choice is Delaware Diversified Income (DPDFX), which returned 9.2% annually during the past 10 years. Of the 495 intermediate-term bond funds tracked by Morningstar, Delaware ranked as the top performer for the decade. The fund achieved its stellar record by holding a mix that included Treasuries, foreign debt, corporate issues and mortgages.

By avoiding richly priced bonds, Delaware navigated through the rollercoaster markets of recent years. Before the credit crisis began in 2006, the fund had 25% of its assets in high-yield bonds, which are rated below-investment grade. But as conditions deteriorated, the fund began unloading its riskier bonds. By the end of 2007, Delaware had only 10% of assets in high yield.

The fund managers steered away from junk because they worried that the market was becoming too complacent about risk. Investors were snapping up shaky issues, and junk only yielded a bit more than high-grade bonds. "A lot of the new high-yield issuance was coming from companies that had unattractive balance sheets," Delaware manager Roger Early says.

The move away from junk proved well-timed, since many lower-rated issues collapsed during the downturn of 2008. Then by early 2009, Delaware began reversing course, loading up on junk bonds. At the time, many junk bonds yielded 1,500 basis points (15 percentage points) more than investment-grade debt. By the end of last year, the fund had more than 30% of its assets in high-yield bonds. The big junk position helped the fund climb as bonds rallied.

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