Are bond funds a ticking time bomb?

If you feel you must have shelter from rising interest rates, shift into a short-term bond index fund.

(Money Magazine)

Pundits have been warning for more than three years that the bond market is a ticking time bomb. But anyone who deserted bonds for the safety of cash back in 2010 has been sorely disappointed, as investment-grade bonds have returned nearly 20% since then, vs. 0.20% for money-market funds.

While most analysts expect interest rates to climb from today's depressed levels -- they've already inched up about half a percentage point since last summer -- no one knows how far they'll rise and how long that will take.

And even though bonds could face difficult times ahead, bailing out may lead to more problems than staying put.

For one thing, you face the question of where to invest instead.

Stocks? The risk of a severe setback is far greater.

Stock prices have dropped by 50% or more twice during the past 13 years alone. The broad bond market has yet to suffer a 12-month loss greater than 9.2%.

You could always hunker down in Treasury bills, money funds, or short-term CDs and jump back into bonds after rates rise. Do so before rates have finished climbing, though, and you could still face losses; stay in low-yielding cash too long, and you could give up a substantial return. It's the same no-win guessing game that many investors play with stocks.

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My advice: Decide how much of your savings should be in bonds -- likely 10% to 20% if you're young, 50% or more if you're nearing or in retirement. Then stick to that percentage regardless of what prognosticators say rates may do, making a total U.S. bond market index fund (VBMFX) your core holding.

Yes, the value of such a fund will drop by roughly 5% for every percentage point that rates increase. Any initial blow, however, would be cushioned by the bonds' interest payments. Plus, your return would rise as older bonds in the portfolio mature and are replaced by higher-yielding ones.

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Still, if you feel you must have shelter from rising rates, shift into a short-term bond index fund (VBISX), which recently yielded just 1.4%, vs. 2.5% for its total bond market counterpart. As rates rise, such a fund should drop roughly half as much.

Finally, since interest rates in other countries don't move in lockstep with rates here, you may be able to get more protection by venturing overseas. The international bond fund on our MONEY 70 list is Templeton Global Bond (TPINX), which lately paid 5.6%. And by midyear Vanguard will introduce an international bond index fund. To be safe, limit foreign bonds to, say, 20% or so of your overall bond portfolio.

But whatever you do, don't abandon bonds altogether: Despite today's low rates, they still deserve a place in your portfolio.