Investing In Bonds Is Risky Again. Here Are Some Tips.

The bond market is getting a reality check: The possibility of a "no landing" situation in the economy will force the Federal Reserve to apply the brakes more forcefully than initially anticipated.

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The Fed's main policy tool for slowing economic growth and containing inflation, the possibility of rising interest rates, pushed bonds into a spiral over the past two weeks. In the upcoming months, a recovery can be challenging. A solid method to weather the volatility and get positive total returns may be to invest in high-quality short-term debt, such as 5% yielding Treasuries.

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Bond prices and yields follow opposing trends, and the past three weeks have been nasty as rates increased. Starting in February, the 10-year Treasury rate was 3.39%. Recently, it traded at 3.94%, a big increase in a short time.

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The market is currently experiencing headwinds. By the end of January, the iShares Core U.S. Aggregate Bond exchange-traded fundAGG +0.36% (ticker: AGG) had increased by 3.3%, interest included. It has already lost almost all of its year-to-date gains, rising just 0.6%.

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The bond market appears concerned that inflation won't slow down quickly enough to attain the Fed's target level of 2% annualized inflation. Further supporting a "no landing" scenario in which the economy resists the Fed's attempts to restrict growth is the continued strength of the job market.

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In addition, inflation expectations are being priced into bonds at a higher level than the statistics would indicate. The five-year Treasury yields have increased by 74 basis points since mid-January, according to Nicholas Colas, co-founder of DataTrek Research. Yet, only 0.43 of a percentage point has been added to five-year inflation estimates.

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According to him, the larger increase in yields indicates that investors are asking for better inflation-adjusted rates of return. In other words, he continues, "the current jump in rates is not solely about inflation." Instead, it demonstrates how risk-averse investors are becoming.

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Other analysts advise taking a safe bet with debt, such as six-month Treasury bills, which now yield 5.1%, given the uncertainties surrounding inflation and the Fed's rate intentions. When adjusted for inflation, that isn't much of a positive "real" yield. Yet, if you keep the notes until they mature, you'll be assured that yield with no risk to your principle, assuming the US government doesn't go bankrupt.

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According to Ed Al-Hussainy, senior interest-rate strategist at Columbia Threadneedle, "you have a great, high-quality short-duration asset, so you're not exposed to a lot of volatility, and the strongest forward-looking income we've seen in a decade." He continues, "That's a really fantastic deal to be able to lock that in.

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While most bond funds have longer durations or higher interest-rate risk than T-bills, corporate debt yields more than Treasury bonds. For instance, the 30-day SEC yield on Vanguard Short-Term Corporate BondVCSH +0.13% ETF (VCSH) is 4.94%. But, if rates continue to rise, its average length of 2.7 years makes it slightly riskier. With interest, the ETF, which follows the Bloomberg U.S. 1-5 Year Corporate Bond Index, has gained 0.4% this year.

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With yields around 7.8% for products like iShares iBoxx High Yield Corporate Bond HYG +0.99%, high-yield, or "junk," bonds may seem alluring (HYG). The ETF, however, carries a large credit risk and has an effective duration of 3.9 years as a rate play. According to overall return, it has increased by just 0.8% this year.

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Some strategists believe that risky business debt offers little benefit. Brian Rehling, head of global fixed-income strategy at Wells Fargo Investment Institute, advises investors not to divest themselves of too much credit quality at first since there will be stronger entry points later.