NEW YORK (TheStreet) -- For a long time it was too easy for investors to turn up their noses at bonds. But last year we got a wake-up call.

In 2000, bond funds outperformed stock funds by a healthy margin, with taxable bond funds gaining an average of 5.7%, according to Lipper, while tax-exempt funds saw average increases of 10.1%. Meanwhile, equity funds fell an average of 4.5%.

"The year just ended is a classic case of seeing bonds being one source of gain when everything else was going down," says David Yeske, a San Francisco-based certified financial planner. Granted, bond outperformance is relatively rare -- according to Lipper, last year was the first time fixed-income funds had bested their equity counterparts since 1994, and only the seventh time in the past 25 years.

But on the plus side, owning even a small amount of bonds can help stabilize your portfolio in rough years. As the chart below shows, having some bond exposure will mitigate your losses in tough times for the market.

If You Own Bonds, You'll Lose Less Money in Down Years...
Stock/Bond Allocation (%)* Number of Years with a Loss Average One-Year Loss (%) Three-Year Loss (%) 1930-1932 Two-Year Loss (%) 1973-1974
100/0 20 -12.3% -60.9% -37.3%
80/20 19 -9.8 -45.6 -29.2
60/40 16 -8.2 -30.2 -21.1
40/60 15 -5.5 -14.9 -13.0
20/80 14 -3.7 +0.5 -4.9
Allocations are rebalanced annually.
Source: Common Sense on Mutual Funds, by John C. Bogle. Period measured is from 1926 to 1997.

Does that mean you should dive head first into bonds? No.

"To the degree you add bonds to your portfolio, you're pulling down the portfolio's overall rate of return," explains Yeske. Over the long term, stocks will still post better returns.

...Though Too Much Bond Exposure Will Hurt Your Performance
Stock/Bond Allocation (%)* Annualized Total Return, 1971-74 Annualized Total Return, 1973-76 Annualized Total Return, 1971-76 Annualized Total Return, 1971-97
100/0 -3.9% 1.7% 6.4% 13.3%
80/20 -1.8 3/1 7.0 12.7
60/40 0.2 4.4 7.4 12.0
40/60 2.1 5.5 7.7 11.2
20/80 3.8 6.4 7.8 10.4
0/100 5.4 7.1 7.9 9.2
Allocations are rebalanced annually.
Source: Common Sense on Mutual Funds, by John C. Bogle.

But depending on your age and your risk tolerance, bonds should probably play at least some role in your overall portfolio. "Bonds have a place, I think, in almost everyone's portfolio, except for those whose goals and risk tolerance are way out at the extreme end of the spectrum," says Yeske. Because owning bonds will probably reduce overall returns, he recommends that investors who have a ways to go before retirement -- people in their 30s, 40s or even 50s -- allocate no more than 15% to 25% of their portfolio to bonds.

Financial experts generally recommend that you stick with bond funds, instead of buying bonds outright, unless you have a pretty sizable amount to invest -- around $100,000 to $150,000, in Yeske's opinion.

The good news is bond funds aren't all that complicated. Consider the conclusions of a study from the Schwab Investment Research Center on what's important in choosing a bond mutual fund. The study, released last year, considered eight factors: risk, expenses, past performance, load fees, turnover, assets under management, cash flow and manager tenure.

The results? Only the first three factors mattered, according to Schwab.

First, let's consider risk. There are basically two kinds of risk for bond investors. The first is maturity risk. Bonds of varying maturities react differently to interest rate changes. Generally, when interest rates decline, longer-term bonds do well relative to short-term bonds. The opposite happens when interest rates rise. (For more on why this happens, read about the workings of the Treasury yield curve.) Basically, if you thought interest rates were headed down -- a highly likely possibility these days -- you'd be inclined to stash money into long-term bonds, which would see the biggest price appreciation.

Except then you'd be trying to time the bond market -- a dicey proposition for the typical investor. "It's really, really difficult to forecast those movements," says Peterson, pointing to the Fed's surprise move last week. "For an individual retail customer, it's probably not a good idea to sit around and try to forecast movements and rates and spreads."

By diversifying across bonds with varying maturities, you can insulate yourself from movements in interest rates. "You want to hold bonds of different maturities -- some short, some long and some intermediate," he explains, "So that when interest rates go up, while some longer-term bonds hurt, there are some shorter-term bonds that you can roll over into higher-rate instruments."

Yeske, on the other hand, suggests simply sticking to funds with an average maturity not greater than five years. "There are a number of studies that have shown that when you buy bonds with an average maturity greater than that, you get more volatility without necessarily getting more total return," he explains.

Back to the second type of risk: Credit risk is the possibility that companies will default on their loans. Here, too, it's a good idea to diversify. "If you want some exposure to a little higher risk, like corporate bonds, that's OK," says Peterson. "But make sure you have some Treasury bonds. You should have bonds that have different default risk characteristics. If you're going to have a little low-grade debt, you want to have some high-grade debt."

Next, expenses. This is an easy one: Because bonds post lower returns than stocks in the first place, expenses will siphon off a higher percentage of any gains. In fact, Schwab found that every 1% increase in the expense ratio is associated with an estimated 0.7%-per-year decline in future returns. In practice, expense ratios range from 0.2% on the low end (for index funds) to 2% on the (very!) high end. "As much as or more than any other place, fees and expenses make a difference when you're buying a bond fund," says Yeske.

Finally, a third factor to consider when buying a bond fund is past performance. Sure, it's no guarantee of future performance. But Schwab found performance ranking within a category to be a useful indicator, especially when combined with a look at fund expenses.

To find funds that fit those parameters, we screened Morningstar for taxable bond funds with lower-than-average risk (a measure of downside volatility relative to other taxable bond funds), lower-than-average expenses and higher-than-average three-year returns. All funds are ranked by performance. (Note: We eliminated a number of institutional funds with minimum investments ranging from $100,000 to $5 million. The only institutional fund remaining on the list, ( FGFSX) Federated Mortgage, has a minimum investment of $25,000. We also removed ( FMSFX) Fidelity Mortgage, which is closed to new investments.)

Bond Funds That Make the Grade
Fund Category 3-Year Performance % Rank in Category by 3-Year Performance (1=Best, 100=Worst) Operating Expenses Risk
(MWTRX) Metropolitan West Total Return Bond Interm-Term Bond 7.37 1 0.65 Low
( MWLDX) Metropolitan West Low Duration Bond M Short-Term Bond 6.80 3 0.58 Below Average
( STHBX) Strong Short-Term High Yield Bond Inv High Yield Bond 6.66 1 0.80 Low
(FGFSX) Federated Mortgage Instl Svc Intermediate Government 6.62 2 0.60 Low
(PYGFX) Payden Global Fixed-Income R International Bond 6.51 7 0.49 Low
Source: Morningstar, as of 1/11/01.

And what about those other five factors the Schwab study considered? Well, it turns out they just didn't matter much. Surprisingly, the researchers found performance of bond funds wasn't significantly tied to the length of manager tenure, the size of cash inflows or even high rates of turnover. And -- no huge surprise here -- the extra cost of load funds wasn't worth it. The Schwab researchers found no evidence to support the claim (advanced by some fund companies) that in exchange for paying a load, you get better-skilled managers who'll post fatter returns.

While bond funds with more assets under management appeared to perform better in the future than those with fewer assets -- presumably a reflection of greater economies of scale and buyer power -- the effect wasn't significant enough to convince the researchers it's worth paying attention to.