Investors seeking to include bond funds in a diversified portfolio need to be careful these days. With a flat yield curve, short-term bonds pay almost as much as long-term bonds. Therefore, you might be better off with short- and intermediate-term bond funds.
Among investment professionals, there are concerns that long-term interest rates will rise. If you invest in long-term bond funds, to get a little more yield, you’ll risk losing principal, because long-term bonds lose value when interest rates rise.
Another possible solution is to invest in TIPS funds–these mutual funds hold Treasury Inflation-Protected Securities (TIPS), which are obligations of the federal government. TIPS will pay higher yields if inflation rises, as many forecasters expect. TIPS funds are available from several mutual fund families, including Fidelity, Vanguard, and PIMCO.
Still another way to reduce interest-rate risk in bond funds is to invest in a fund such as Fidelity Floating Rate High Income Fund, which invests mainly in bank loans. If inflation increases and interest rates move up, the rates on those bank loans will go higher, so payments to investors will rise.
