NEW YORK ( TheStreet ) -- Many bond ETFs have sunk lately. During the past year, Vanguard Intermediate-Term Bond (BIV - Get Report) lost 3.44%, and iShares Core Total Aggregate US Bond (AGG - Get Report) 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 - Get Report) 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.
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 - Get Report), 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.
Lord Abbett currently has 40% of assets in corporate bonds, including a stake in high-yield issues, which are rated below-investment grade. The managers shift allocations as conditions change. Most often, the moves have been on target. During the past five years, the fund has returned 7.0% annually, outdoing 95% of short-term funds.
As markets began reaching a trough in 2009, the Lord Abbett portfolio managers began buying riskier commercial mortgage-backed securities. Those are based on loans for commercial properties, such as office buildings and malls. Before the financial crisis, investment-grade commercial mortgages had been considered sound investments that only yielded a percentage point more than Treasuries. Then, as defaults rose, prices of the mortgages crashed, and investors demanded yields that were 14 percentage points over Treasuries.
Lord Abbett grabbed high-quality mortgages and scored big gains as the market recovered. The portfolio still has 16% of assets in commercial mortgage-backed securities. "Commercial mortgage-backed securities suffered huge dislocations in 2008, and they still represent relative value," says Lord Abbett portfolio manager Stephen Hillebrecht.
The fund has 20% of assets in high-yield bonds. Those have delivered big gains as default risk has declined and prices rebounded up from the lows. The Lord Abbett portfolio managers limit risks by focusing on bonds that are rated BB and B, the two highest grades in the below-investment grade universe. The fund also emphasizes bonds with maturities of one and two years. Those have suffered relatively low default rates. With the economy growing and interest rates low, companies have been able to refinance debt before they run into trouble.
At the time of publication the author had no position in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.