Getting Ready for a Bond Bear Market

NEW YORK ( TheStreet) -- Since the financial crisis, some financial advisers have warned repeatedly that the long rally in bonds could end soon. So far the pessimists have been wrong. During the past three years, the average intermediate-term bond fund returned 7% annually, according to Morningstar.

But lately the bears have been joined by some prominent fund managers who argue that the bond markets are about to enter harder times. With the government running huge deficits, inflation will appear and drive up interest rates, the managers worry. When rates rise, bond prices tend to fall.

Among the noteworthy figures sounding a cautionary tone is Jeffrey Gundlach, the star manager of DoubleLine Total Return Bond ( DBLTX). A longtime critic of Washington's policies, Gundlach has taken defensive steps, increasing his stake in cash, which can hold its value in a downturn. The portfolio now has 19% of assets in cash, up from 7% two years ago.

In addition, Gundlach has lowered his fund's duration, a measure of the portfolio's sensitivity to rising interest rates. The fund now has a duration of 1.6 years. So if rates rise by 1 percentage point, the fund could lose 1.6%. Two years ago the duration was 3.9 years.

Another prominent bear is Ben Inker, co-head of asset allocation for GMO, who manages Wells Fargo Advantage Asset Allocation ( EAAFX). GMO forecasts that U.S. bonds will enter a prolonged slump, losing 1.2% annually for the next seven years. The Wells Fargo fund holds a mix of stocks and bonds. But lately Inker has been lowering the bond allocation. The fund currently has 11% of assets in bonds, down from 22% in 2009.

Should you avoid bonds altogether? Probably not. The bond bears could be wrong again. The Federal Reserve has pledged to hold down interest rates into 2014. If that happens, bond prices could remain firm for at least another year. Whether or not rates rise, a solid bond fund can help to diversify a portfolio.

Still, this is a time for caution. One way to limit risk is by holding shorter bonds. Those tend to be relatively resilient in downturns. Many of the biggest bond funds are intermediate-term portfolios that are benchmarked against the Barclays Aggregate U.S. Bond Index, which has a duration of 5.1 years. For a bit less risk, consider a fund that is benchmarked against Barclays Capital Intermediate Government/Credit Index, which has a duration of 3.9 years.

A solid performer that tracks the intermediate government/credit benchmark is BMO Short-Intermediate Bond ( MAIBX), which has a duration of 3.2 years. Portfolio manager Jason Weiner has reduced his duration to prepare for hazards in the bond markets.

"If we get a resolution of the fiscal cliff, then we could see rates moving higher in the second half of 2013," says Weiner.

The Barclays Aggregate has 20% of its assets in corporate bonds, with most of the rest in Treasuries and government-backed securities. Weiner has 54% of assets in corporates. Those yield more than Treasuries. If the economy improves and rates rise, then corporates would likely outdo Treasuries. Corporates tend to shine when the economy strengthens because investors worry less about defaults.

Loomis Sayles Intermediate Duration Bond ( LSDRX) has a yield of 2.3%, about the same figure as the Barclays Capital Aggregate index. But with a duration of 3.9 years, the Loomis Sayles fund has less interest-rate risk than many competitors.

To boost returns, portfolio manager Chris Harms emphasizes corporate bonds and other issues that come with credit risk. He has 7% of assets in commercial mortgage backed securities, which yield a percentage point more than Treasuries. The securities are backed by loans for commercial properties, such as offices and apartment buildings. While CMBS can default, Harms limits risk by focusing on issues with the top rating of AAA.

Harms says that his CMBS and corporate holdings should prove relatively resilient in a bond bear market.

"The portfolio is well-positioned to withstand a gradual rise in interest rates," says Harms.

Baird Intermediate Bond ( BIMSX) has a duration of 3.9 years and a yield of 2.6%. The fund has boosted its yield by underweighting Treasuries and putting 48% of assets in corporate bonds. Portfolio manager Warren Pierson argues that corporate bonds are relatively safe bets these days.

"It makes sense to overweight corporates at a time when most corporate balance sheets are in good shape," he says.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.