Bonds: A future of lousy returns?

(MONEY Magazine) -- For bond fund investors, there's little good news. The decades-long decline in interest rates, which pumped up returns, has hit rock bottom. Inflation and higher rates must loom ahead -- and when rates rise, bond prices fall. Is there anything you can do besides accept a future of lousy returns?

Perhaps -- but only if you are willing to take a leap of faith. A new kind of bond fund, called unconstrained, aims to avoid the losses that come with rate hikes while still delivering solid, long-term returns.

Unlike core bond funds, which own U.S. investment-grade bonds, these funds give their managers a free hand to buy almost any kind of bond. That could mean emerging-markets, junk, munis ... whatever. The funds may also use complex hedging strategies, such as buying derivatives or shorting -- betting that particular bonds will fall in value.

These tactics give managers maximum flexibility to adjust their funds' duration, which is a measure of sensitivity to interest rates. Unusually, the funds can even have a negative duration. The shorter a fund's duration, the less it stands to lose if interest rates rise; if duration is negative, the fund can actually make money when rates spike.

Nervous bond investors are taking to the strategy. The first fund off the block, $14.5 billion Pimco Unconstrained Bond (PUBAX), launched in June 2008. Last year alone it pulled in $10.6 billion in new cash, even as shareholders yanked $6 billion from its core bond fund sibling, Pimco Total Return. Recently the fund held a slightly negative duration.

"We're expecting higher inflation and higher interest rates as the Fed's buying Treasuries comes to an end," says manager Chris Dialynas. A no-load version of the Pimco fund, Harbor Unconstrained Bond (HAUBX), opened its doors last April -- it charges 1.05% vs. 1.3% for the Pimco fund.

Hot on Pimco's heels, J.P. Morgan, AllianceBernstein, and Loomis Sayles have gotten into the unconstrained business too.

Something that makes this more compelling than most financial services "innovations" is that Pimco, one of the best bond shops in the business, is doing it.

"They have a long track record and lots of expertise running a global bond portfolio," says Jeremy De-Groot, chief investment officer at Litman/Gregory. If fear of higher rates is keeping you up at night, putting a portion of your bond allocation -- say, 20% -- in the Harbor fund is reasonable.

Why not go all in? Two reasons. First, these funds have short records. Returns depend on the manager's ability not only to select bonds but also to make complex hedging decisions.

"When managers are free to use more strategies, a lot more can go wrong," says Eric Jacobson, Morningstar's director of bond research. Other funds using hedging tactics have had mixed results.

Second, it's one thing to protect yourself by buying a low-duration fund. But an unconstrained fund can lose money if its manager's pessimism is misplaced. So even if you are willing to take a chance on a new idea, you'll want the diversification you get by holding a plain-vanilla bond fund, too.