Creating a winning bond strategy: with the right approach, bonds can achieve outstanding returns in a volatile market. Here's how.

While shopping for mortgages to refinance her three-bedroom, loft-style home in a Los Angeles suburb and her vacation condo in Nevada, Karen Ellis couldn't find anything better than a 5.8% interest rate on a 30-year fixed loan. That's lower than the 7.25% rate she now carries, but hardly the giveaway she could have gotten in 2003 when mortgage rates fell below 5%. It's important for Ellis, a 57-year-old pathologist, to trim as much cost as she can now because her expenses are rising in a number of areas. She's seen gas prices spike in the last year, which had her shelling out $45, which is 50% more than the year prior, each time she filled the tank of her Lexus sedan.

A conversation with her financial adviser, Alfred McIntosh of McIntosh Capital Advisors L.L.C., hipped Ellis to the fact that interest rates were rising and she needed to make some adjustments. With roughly 40% of her investments in bonds, Ellis' portfolio could suffer if rates go even higher. Since Ellis wants to retire from her job at a local hospital by 2009, it's important that she prevent her principal from taking a major hit before then.

McIntosh helped Ellis come up with a solution. They moved a portion of Ellis' bonds to shorter maturities--the date when the bond's value should be paid--because they are less sensitive to interest rate swings. High-yield bonds, better known as junk bonds because of their low credit rating and low sensitivity to interest rates, were added, with a smattering of mutual funds that invest in bonds overseas. Finally, McIntosh recommended church bonds: debt issued by houses of worship that pay higher rates. Church bonds with a 6 1/2-year maturity yield between 5.2% and 5.9%. Bonds with a 9 1/2-year maturity yield between 6.2% and 6.9%.

While most investors have been focusing on the equity portion of their portfolios, conscientious investors like Ellis are tweaking their bond portfolios in light of today's economic forecast. Bonds should be an important part of everyone's investment strategy. "I'm afraid that interest rates are going higher," says Ellis, "that's why I have diversification in my bonds, so they provide more security in my portfolio."

If interest rates rise, some bond holdings could take a hit that individual investors wouldn't expect from such safe instruments. Bonds are supposed to he that portion of every investor's portfolio that helps them sleep at night. You're not likely to get rich, but you're not likely to lose your shirt either. That's not to say that there isn't any risk

For the last five years, the average bond portfolio has returned a cumalative 46.4%. The same investment in the Standard & Poor's 500 Index, however, has produced a 8.6% loss. Even though bonds have performed better than equities in the last five yeas, long-term interest rates are now at 40-year lows. Bond prices drop when interest rates rise because investors aren't willing to pay premium prices for older, lower-yielding bonds when new ones pay more.

Going forward, industry observers are predicting that bond performance will be much slower. "The tailwind for bonds has abated," says Edwin Ek, chief investment officer of RhumbLine Advisers in Boston (No. 3 on the BE ASSET MANAGERS list with $7.4 billion in assets under management). "There's no doubt that we've hit bottom and are bouncing back up."

Some analysts are even more gloomy. "We think we're in a bond bubble," declares Mark Lay of MDL Management in Pittsburgh (No. 5 on the BE ASSET MANAGERS list with $3.81 billion in assets under management). Lay's firm, which specializes in bond investing, believes interest rates have stayed low for so long because investors around the world have turned to bonds as a safe haven to park their money in light of so much global uncertainty. That huge demand has boosted long-term bond prices and sunken yields.

But Lay says economic changes are afoot. The U.S. gross domestic product is now growing at 4% a year, a healthy clip of economic activity after the recession of 2001 and 2002. When the economy is doing well, investors prefer stocks, so they're likely to pull money out of bonds, causing prices to fall and rates to rise.

Another argument that rates will rise is that inflation, long thought dead, has recently resurfaced. Just look around. Job-based health coverage costs are 60% more today than they were five years ago. Home prices in areas like California and Nevada have surged 80% in the last three years, according to the National Association of Realtors. Inflation, the byproduct of increased economic activity, is every bondholder's fear because it erodes the total returns of fixed-income portfolios.

To curb inflation, the Federal Reserve raised short-term rates six times, from 1.0% to 2.5%, since June 2004. But the Fed only controls the shortest rates. The market takes care of the rest. Ten-year Treasury yields haven't budged at all; in fact, they've fallen. In January 2004, the 10-year logged a 4.26% yield. A year later, it had a 4.19% yield. With yields so stubbornly low, it might be a cue that all the hype about the improving economy may be just that.

"I think that bonds will have a decent year," says Mary Pugh, president and CEO of Pugh Capital Management in Seattle (No. 15 on the BE ASSET MANAGERS list with $674 million in assets under management). "They'll be in more of a trading range, with a possibility that rates will go down."

Pugh's view of bonds stems from her bearish thoughts on the economy. She believes that globalization and technology will put downward pressure on inflation and employment. At the same time, economic activity could be moderate because the refinancing boom has slowed and consumers don't have as much money in their pockets to spend. Overall, Pugh thinks the 10-year bond could end the year just about where it started.

"I know I may be in the minority," says Pugh, but it often pays to heed contrarian calls. A year ago, the investing pros thought interest rates were going to rise too. They were wrong.

So what's a bond investor to do? We've laid out four bond strategies that should help you make money in the asset class no matter which way the economic wind blows. We'll also tell you how each type of strategy works when interest rates rise to help you minimize any damage.

Laddering For the last five years, G.G. Washington, a retired information technology director, has devoted the bulk of his fixed-income investing to laddering, a strategy that spreads money among different investment bonds that mature at different intervals and are reinvested at the best possible rates up until a designated time horizon. Washington divides his money into five equal pieces. Every two years, he invests in bonds with maturities ranging from two to 10 years. Among his holdings are bonds from General Electric, Loews, Lehman Brothers, and Ford, his former employer. Because bondholders are taxed on income from corporate bonds, Washington holds them in his 401(k), which is tax-deferred.

When a bond matures, Washington puts the money into a new 10-year bond. Every two years, a fifth of his portfolio comes due and he invests the proceeds into the longest dated bonds available.

"These are investment grade bonds, so I was pretty comfortable the corporations would not default," says Washington, 58, who now does IT consulting for businesses and schools. "I hold them to maturity, so I'm not impacted by interest rate fluctuations."

Should rates rise, though, Washington can reinvest at the higher rate when a bond matures. If they fall, which has happened over the last few years, the overall yield of the bond portfolio will fall too if reinvesting is done in lower interest bonds. However, this strategy allows for reinvestment in other fixed-instruments until corporate bonds are favorable. But, Washington still has a corporate bond in his portfolio issued by GTE North Inc. that yields 8.25%. He purchased the bond in 2000 when rates were higher. The bond matures in 2005.

By laddering between one and 10 years, "effectively, what you end up with is the risk characteristics of a five-year bond," says Steve Bohlin, manager of the Thornburg Limited Term Income Fund in Santa Fe, New Mexico, which uses a laddered approach. "Historically that's been the best risk-reward relationship."

Most advisers caution that you'll need at least $10,000 to invest per bond. Otherwise the hefty commissions will greatly reduce the returns you'll receive. Investors can achieve results similar to Washington's laddering strategy by investing $10,000 or more through bond mutual funds.

Intermediate Bonds You would think that with interest rates being so low, you'd want to invest in longer dated bonds because they'd pay more. Hardly.

"Given the current interest rate environment, I think long-term bonds are not a good choice," says Stephanie Hancock, financial planner and owner of Hancock Wealth Advisory in Los Angeles. "I tell my clients to stay in the one-, two- and three-year range."

If the purpose of your bonds is to provide stability to your over-all portfolio (as opposed to generating income to live on), invest in bonds that are the least volatile. Prices for shorter dated investments don't move around as much as those maturing later on.

Of course, short bonds yield less than those with longer time horizons, since investors don't expect the same kind of reward for lending money for five years as they would for 10. Therefore, a 10-year Treasury note yields 4.17% today, but the five-year sports just a 3.5% yield. "I would be focusing on figuring out the point where you get the most yields for the least amount of interest rate risk," says Pugh. "For an individual, it's the intermediate maturities."

You could put new money to work in the shortest dated bonds to even out longer bond holdings. Or you could sell everything and simply buy within the five-year range. Alternately, you can invest in a fund that plays the intermediate segment of the bond market such as the Vanguard Intermediate-Term Bond Index Fund (800-662-7447). The fund has a 6.8% three-year annualized rate of return.

Junk Bonds Another way to stem the damage from rising rates is to look at junk, or high-yield, bonds--those given a grade of BB or lower by one of the credit rating agencies such as Standard & Poor's or Moody's Investors Service. The juicy yields make them less sensitive to interest rates, since investors determine prices by judging a company's ability to pay back its debt, not the direction of interest rates.

Over the last two years, as the economy has revived and corporate finances have improved, investors have become downright smitten with junk. Whereas in mid-2002, high-yield debt paid over 10 percentage points more than Treasury bonds with similar maturities, today that yield differential is just 3.5 percentage points. Last year, junk bonds returned 10.9% on top of a 28.2% gain the year before--results that bested equities.

"There's some bang for the buck in high-yield bonds," says Ek. "You might say that the risk/return is not as fat as it has been, but you are still being rewarded incrementally for taking on that credit risk."

Extra yield, plus less interest rate sensitivity. Sounds good, right? Not so fast. Putting just 5% to 10% of your bond portfolio into junk bonds is plenty. "When things go bad in high-yield, it happens very quickly," says Ned Notzon, a bond manager with T. Rowe Price Investments in Baltimore. "It can happen in just a few months' time. You're very unlikely to see investment-grade corporate [bonds] behave that way."

Try a fund like T. Rowe Price High-Yield (800-638-5660). It has an 11.3% three-year annualized rate of return.

Mutual Funds For the vast majority of investors, a low-priced bond fund will suit them fine. Just ask Donna Ginn, owner of a Miami-based organization and management development firm, Ginn Scroggins & Associates. Ginn, who is in her mid-50s, is worried that interest rates will wreak havoc on the 40% of her portfolio she has allotted to bonds. So she's shortened the over all maturity of her portfolio, bought international fixed-income securities, and added some floating-rate bonds that respond quickly to rising rates. But she's done it all through mutual funds.

"I know there will be a point when I won't be working as much, and I don't want to compromise my lifestyle one bit," Ginn says. "Bond funds will help me do that."

Individual bonds certainly have their merits. If you plan to bold them until maturity, price fluctuations don't matter. The amount you invest is the amount you'll receive when the bond comes due. Mutual funds, however, price their bonds daily. So when interest rates rise, their returns are likely to suffer. With individual bonds, you won't pay the 1.14% management fee that the average bond fund charges. But remember, just as you wouldn't buy one or two stocks and call your portfolio complete, you should have enough diversification so that if one bond defaults, it won't be your portfolio's undoing. Given how expensive it is to buy individual bonds, it's almost impossible to put together a diversified portfolio for less than $100,000.

One exception is Treasury bills. They're simple to buy directly from the Treasury Department in increments of $1,000 and, since it's the world's best quality bond, there's no credit risk. Go to www.publicdebt.treas.gov to find auctions.

If you're looking for just one all-weather bond fund, try Harbor Bond Fund (800-422-1050). It has a 6.6% three-year annualized rate of return and is managed by Bill Gross, who is considered to be the best bond investor in the world. It's a virtual clone of Gross' flagship PIMCO Total Return Bond Fund, without the sales charge.

Karen Ellis portfolio

10% Ultrashort corporate bonds Scudder Preservation Plus Income

22% Intermediate government bonds American Century Inflation-Adjusted Bond and Dimensional Intermediate Government Fixed-Income Fund

18% Intermediate corporate bonds Calamos Convertible Bond and Calvert Income

23% International bonds Oppenheimer International Bond and Payden Emerging Markets Bond

27% High-Yield California Baptist Foundation church bonds One maturing in 2007 yielding 6.3% and another maturing in 2011 yielding 7.8%

40% OF ELLIS' OVERALL PORTFOLIO IS IN BONDS.

56% Bond Ladder Various corporate bonds

15% Foreign and domestic bonds PIMCO Diversified Income Fund

15% Floating rate bonds PIMCO Floating Income

14% Intermediate bonds PIMCO Total Return

35% OF WASHINGTON'S OVERALL PORTFOLIO IS IN BONDS.

Donna Ginn's portfolio

40% Intermediate bonds T. Rowe Price Spectrum Income

20% Floating-rate bonds ING Senior Income Fund

20% Long government bonds PIMCO Real Return

20% Short bonds Scudder Preservation Plus Income Fund

40% OPF GINN'S OVERALL PORTFOLIO IN BONDS.