A low-risk strategy that pays as rates rise

Bond-fund investors, for whom 2004's gentle rise in bond yields posed few problems, face a more challenging future.

In mid-March, the Federal Reserve engineered the seventh quarter-point boost in its benchmark Fed funds rate in less than a year. Though widely anticipated, Fed Chairman Alan Greenspan's warnings about creeping inflation caught many bond-fund managers off guard. As a result, bond funds fell (as they usually do when interest rates rise).

The average domestic long-term bond fund declined 0.8 percent during the quarter. Since the Fed is expected to continue raising interest rates for the remainder of the year, bond prices may well remain under pressure, analysts say.

In such an adverse environment, fixed-income investors should keep their bond maturities short and credit quality high, advises Christopher Neubert, a financial planner at the Southport, Conn., office of Moneco, an asset-management firm. Sticking spare cash into money-market funds or short-term bond funds with average maturities of two or three years will offer some protection against rising rates. Such funds are able to refresh their portfolios by buying higher yielding paper as rates go up. Thus, they will generally retain their net asset value better than long-term bonds, which are more exposed to loss of principal.

One low-risk, yield-enhancing strategy Mr. Neubert favors is the use of bank-loan funds. These funds, which currently yield about 3 to 4 percent, buy slices of floating-rate loans that banks make to noninvestment-grade corporate borrowers. The interest rates on these loans are reset every three to six months. As a result, investors in these funds pick up bond-like yields with minimal fluctuation in the net asset value of their funds.

Although the loans aren't rated by credit agencies the way corporate bonds are, they are secured by collateral, and default risk is very low, according to Neubert. Prominent among his favorites are bank loan funds sponsored by Highland, Eaton Vance, and Fidelity.