Bond mutual fund investing in 2013 will likely prove to be more challenging than that of 2012. The Federal Reserve has already indicated that it will decrease its "quantitative easing" or "QE3" efforts over the last months of 2012 and first months of 2013. This may indicate that bond prices could begin their decline at some point in the near future.
How to Invest in Low-Rate, Inflationary Environments
Of course there is no way of really knowing what kind of economic environment will transpire during the course of the year but 2013 is likely to be a year of either slow growth (modest inflation) or no growth while inflation continues to rise (stagflation). No matter how you look at it, 2013 could finally be that tipping point that bond fund managers and economists have warned about--the end of a bull market for bonds and the beginning of a bear market--a time when interest rates begin to climb as bond prices begin to fall.
The best way to invest in bond funds during rising interest rates is to either focus on short-term and intermediate-term bond funds or to diversify with various types of bond funds for diversification. By using bond funds with shorter average maturities, you can minimize the negative effect of falling prices. In theory, the longer the maturity, the more prices or the mutual fund's net asset value (NAV) will fall as interest rates rise.
In this case, investors can consider a good short-term bond fund, such as PIMCO Low Duration D (PLDDX) or an intermediate bond fund, such as Harbor Bond (HABDX). Some investors like to use Treasury Inflation Protected Securities (TIPS) to fight inflation. An example is Vanguard Inflation-Protected Securities Fund (VIPSX). However, funds investing in TIPS are still exposed to the downside risk of falling prices as interest rates rise. Therefore the time for using TIPS in mutual funds may have passed.
Investor Caution: Bond Strategy Depends Upon Purpose for Fixed Income
Above all, investors should determine their purpose for using bond funds: Are you looking for income or are you looking for a diversification tool? Are you a short-term investor or are you a long-term investor? In general, short-term investors that have a need for income, such as those who are in retirement, need to be mindful that they may receive higher yields with some mutual funds but that prices will fall, which will pull down their account value and thus potentially pull down their income dollar amounts. These investors may consider a bond laddering strategy or stock mutual funds that pay dividends.
Long-term investors will have little or no concern over income needs but will likely use bond mutual funds as diversification tools in a balanced portfolio. Depending upon risk tolerance and investment objective, these investors could take more risk and diversify with a "multi-sector" bond fund, such as Loomis Sayles Bond (LSBRX).
Also, investors should also consider tax consequences and review the basics of mutual fund taxation (or what I call asset location) which will depend upon the type of account (i.e. taxable brokerage account or tax-deferred IRA).
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.