NEW YORK (Money Magazine) - It's Economics 101. Stocks have been sizzling. Interest rates have been rising. So bonds inevitably had to suffer.

Since the start of the year, the Lehman Brothers aggregate bond index is up just 1.7 percent following a 10 percent annualized return over the previous three years.

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That's no surprise to Pimco's Bill Gross, FPA's Robert Rodriguez and Vanguard's Paul Kaplan -- a triumvirate of the world's brightest bond minds. Together they manage nearly $400 billion in fixed-income assets. Their styles and specialties differ, but they all agree on this: Investors should look to yield rather than to capital appreciation as the main source of investment returns.

Top picks Bond experts  Pick  Bill Gross  Treasury inflation-protected securities  Paul Kaplan  Ginnie Maes   Robert Rodriguez  Money markets   Source:  Money magazine 10/2003

The key today is to stay defensive, says bond king Gross, whose $72 billion Pimco Total Return is the country's largest mutual fund (thanks in part to the bond boom). A year ago he had almost a quarter of his portfolio in foreign bonds.

But as of Aug. 31, Gross had whittled his stake in foreign bonds down to just 1 percent of assets and quadrupled holdings of government bonds such as Treasury Inflation-Protected Securities (TIPS) from 9 percent a year ago to 37 percent today. Another 8 percent of his fund is sitting in cash.

Gross, in fact, thinks the best opportunities are in TIPS, which automatically adjust principal and interest payments for inflation. Some 10 percent of Pimco Total Return (PTTAX) is in TIPS. More telling, Gross is putting personal money into TIPS.

Pimco Real Return (PRTNX), managed by John Brynjolfsson, is one of the funds that specializes in TIPS, or you can buy them from the government at treasurydirect.gov.

And what is maverick fixed-income investor Robert Rodriguez up to? Rodriguez, who says he likes to "stay out of the mainstream because most of the time the mainstream is wrong," is also playing defense.

Currently his FPA New Income's (FPNIX) duration -- a measure of interest-rate sensitivity -- is around 1.4 years, a remarkably low level. He's piled more than 30 percent of the fund into liquid assets like money markets and some 20 percent into short-maturity TIPS.

Essentially, he's preparing for a major bond market blowup and plans to wait on the investing sidelines until he sees more attractive opportunities. "There is no value in high-quality bonds, and so we're not going to play," says Rodriguez.

Our third bond pro, Paul Kaplan, heads up Vanguard GNMA (VFIIX), the nation's largest mortgage-backed securities fund, as well as manages the bond portion of the 74-year-old Vanguard Wellington fund.

Kaplan also sees bonds coming to the end of a 20-year bull market. The smart buys now, he argues, are in his backyard: mortgage-backed securities. In fact, even in the diversified Wellington portfolio he has loaded up on Ginnie Maes (pools of home mortgages guaranteed by the Government National Mortgage Association), and he has some of his own money invested in them.

Kaplan argues that ultra low interest rates have fueled a record number of mortgage prepayments, which has pushed down the yields on such securities. But rising mortgage rates (30-year fixed rates are up to 6.25 percent from 5 percent three months ago) should curb homeowners' appetite for refinancing, shoring up the securities' yields.

Nonetheless, Kaplan cautions investors not to expect the 10 percent or so total returns that mortgage funds chalked up in the past three years. Returns going forward will be more in line with historical yields, which range from 4 to 5 percent.