What are the Safest Bond Funds if the Bond Bubble Bursts in 2011 ?

The Bond Fund Bubble

Lately, the phrase “bond bubble” is being used increasingly in financial circles. Even Warren Buffet has compared the Treasury market to the earlier housing and internet stock bubbles. So if bond funds aren't safe, what should you do?

Bond Yields and Bond Prices

First, you need to understand why so many strategists are concerned. It starts with the relationship between bond yields and bond prices.

During the recent credit crisis, Treasury bond yields fell to a the lowest levels in decades. As yields dropped, bond prices rose, to what many analysts felt are now unsustainable levels. When yields begin to rise, as many economists expect to happen in 2011, bond prices will decrease. This decrease  has already begun for long-term bonds, providing a preview of what the future might hold for investors in short and intermediate term bond funds.

However, no one knows how much rates will rise or when. And regardless of how much rates rise and when, most investors will still want to own one or more bond funds for diversification.

5 Things To Rember When Investing in Bonds

The following are some things to keep in mind to "weather the storm" of any rough times ahead in the bond markets.

1. Embrace the reality that the bond bull market is a thing of the past. For almost three decades, falling bond yields boosted returns. Given current yields, annual returns on intermediate-term Treasury bonds over the coming decade will likely be about half the 8.4 percent they provided from 1982 through 2008.

2. Focus on your long term investment strategy and don't change your plan. in response to the market’s short-term moves. Once you’ve chosen an asset allocation mix, balancing your need for growth with your desire for protection, resolve to stick with it. Although owning a bond fund will mean taking earning less on the bonds in the fund when rates rise,the fund will also invest in new, higher-yielding bonds, which will soften the blow.

3. Stay with short term bond funds for now. The longer a bond fund’s duration, the further it will decline in price if interest rates rise. Since rates are more likely to rise than to fall in the next few years, you might consider trading current income for protection from rising rates with short-term bond funds. Short-term bonds tend to hold their values fairly well when interest rates rise because investors will get their money back soon, so they won’t suffer below-market yields for very long. You can shift a proportion of your short-term bond fund holdings into longer-term bond funds at fixed intervals over time.

4. Look for short-term bond funds that have been less risky than their peers. Focus on those funds with very low fees and no loads, or sales commissions, as any type of charge can seriously undermine yields when interest rates are as low as they are today.

5. Remember risk and reward and don't chase higher yield without considering the risk. If there is a difference in a bond fund yield, the higher yielding bond has a very high chance of carrying higher risk. It's as simple as that.  In general, the safest short-term bond funds would be Short-Term Treasury Funds. Short-Term Bond Index Funds would be the next safest and Short-Term Investment-Grade Funds would be the riskiest of these three short-term bond funds.