Some Bond Funds for Dangerous Times - TheStreet

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.

Vanguard's $15 billion

(VFSTX) - Get Report

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) - Get Report

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) - Get Report

and

ChevronTexaco

(CVX) - Get Report

. 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)

and

Freddie Mac

(FRE)

, 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%.

Rodriguez's fund carries a 3.5% front-end load to pay for all that activity, but its expense ratio is 0.58%. According to Morningstar, the standard expense ratio for the intermediate-term bond fund category is 1.06%.

Whether or not you classify FPA as an intermediate-term bond fund anymore might be debatable. But judging from his actions, you can unequivocally say that Rodriguez won't play Daffy Duck to the Fed's Bugs Bunny.

When the Federal Reserve starts moving interest rates higher, Rodriguez will not be nodding along.