NEW YORK ( TheStreet ) -- Many bond ETFs have sunk lately. During the past year, Vanguard Intermediate-Term Bond (BIV) lost 3.44%, and iShares Core Total Aggregate US Bond (AGG) lost 2.0%. Rising interest rates caused the damage. Rates on 10-year Treasuries climbed from 1.9% at the beginning of 2013 to more than 3.0% by yearend. When rates rise, bonds tend to sink.
Now many economists forecast that rates will continue climbing. Should you dump your bond funds and shift to cash? Not necessarily. Cash yields next to nothing, and there is no guarantee that rates will rise this year. To prepare for uncertain markets, it pays to diversify bond portfolios, holding a mix of different maturities and credit qualities.
Some sound choices include short-term corporate funds. Many of those have stayed in the black. During the past year, Vanguard Short-term Corporate Bond (VCSH) returned 1.3%, while SPDR Barclays Capital Short Term Corporate Bond (SCPB) returned 1.2%.
During periods of rising rates, short-term bonds tend to suffer only limited losses. Short-term corporate issues can do particularly well if rates are rising as the economy grows. During such times, the risk of default declines and investors can bid up prices of corporate bonds. In contrast, Treasuries receive no boost from economic growth because they do not present default risk.
The Vanguard and SPDR short-term funds did especially well last year because both have big holdings of bonds from financial issuers, such as Goldman Sachs (GS - Get Report) and JPMorgan Chase (JPM - Get Report). Those companies have been helped by strengthening housing markets and improving conditions on Wall Street.
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If the economy continues mending, corporate bonds should again fare relatively well this year. But don't expect any big gains. Corporate bonds have already enjoyed a big rally since the market hit a trough during the financial crisis. The Vanguard fund only yields 1.4%, while the SPDR fund yields 0.9%. Still, there is a good chance that the two funds will again return around 1%.
For heftier results, consider actively managed mutual funds that focus on short-term corporates. A solid choice is Lord Abbett Short Duration Income (LALDX), which returned 1.7% during the past year. While the average short-term mutual fund has a yield of 1.0%, Lord Abbett yields 2.4%. The portfolio managers achieve the extra payout by holding a mix that includes mortgage-backed securities, Treasuries, and corporate bonds.