(FORTUNE Magazine) – Who says that bond investors don't care about growth? During ten years as head of fixed-income funds at the Vanguard Group in Valley Forge, Pennsylvania, Ian MacKinnon helped the company's bond funds expand from $1.7 billion in assets to $36 billion. With short-term interest rates down, the move into Vanguard's longer-term bond funds has lately become a stampede -- assets are increasing by roughly $1 billion a month. But MacKinnon is leery of the new bond bulls. There are bargains in this market, he says, but there is plenty of peril too, and yield chasers may be in for unpleasant surprises. In an interview with Fortune's Andrew Serwer, MacKinnon tells how to avoid the pitfalls.

With short rates down near 5%, shouldn't investors be snapping up long bonds? Only if they understand the risks. We think the huge volume of dollars moving into long-term bond funds is scary. We're not convinced that investors really appreciate the extra risk they are taking for the extra income. We have intensified our warning to investors about longer maturity bonds (see chart). I am reminded of early 1987, when the money flows into bond funds were just as large. Investors seeking higher yields were rushing in with little regard for risk. In April and May of that year long-term interest rates exploded over one percentage point. Investors lost a lot of money. There was a palpable feeling of anguish on the part of our shareholders. We are bending over backward to make sure that doesn't happen again.

Are you looking for a spike up in rates? No. I believe that over the next year or so rates will either continue to drop or hold where they are. Inflation has fallen from 4.6% on an annualized basis to 3.5% over the past six months. A recovery is ultimately inflationary, but there is a lag. It might be a year or so until inflation worsens. In fact, it sometimes moves even lower during the early stages of a recovery, as I think it will this time around. Even so, people who go into long-term bonds may be caught by surprise when inflation and interest rates start heading back up.

How then should you play the bond market? Given that we see rates falling slightly or holding steady, we'd be inclined to invest in the short to intermediate sectors of the market, say bonds with three- to five-year maturities. With these bonds you would pick up some additional yield beyond money markets without the risk of a long bond.

Which funds do you mean specifically? Well, our short-term portfolio is yielding around 7%, compared with our money market fund, which is 5.6%. You're getting almost 1 1/2 percentage points more by extending from a 50-day average maturity to a maturity of two years and change. Also, our bond market fund, which is a broad bond index fund made up of investment-grade securities, yields about 7.8%. Its bonds have an average maturity of around 9 1/2 years. That's about as far out as you have to go in maturity to get good yield. Go out much further and you are taking on unnecessary risk.

What about tax-exempts? We like municipal bonds. Right now munis are yielding about 85% as much as Treasuries. That's at the attractive end of their historical range. Long-term muni bonds are yielding 6.6% to 6.8%, and we think a number of factors will produce outsize price appreciation in these securities. The aging of baby- boomers will push more people into tax brackets where they will benefit from munis. Plus we look for tax rates to move up marginally. That will increase demand. Also, some $200 billion of bonds will be called away by mid- decade. That will decrease the supply. Overall, we see this increasing demand and decreasing supply helping munis to outperform other fixed-income securities. This is one sector of the bond market where it may be wise to buy longer maturities.

Is investing in a Ginnie Mae fund a smart move too? Ginnie Mae funds have been the principal beneficiary of this recent flood of new money. Our GNMA fund, which invests in mortgage-backed securities guaranteed by the government, is yielding 8.33%, which appears tempting. But people have to understand the risks involved. When rates fall, homeowners prepay mortgages, and that will lower the yield on the fund. Even though the spread between Ginnie Maes and long-term Treasuries looks sizable at 1.1 percentage points, historically that is not a very large difference.

What about the king of high yields -- junk bonds? This sector has bounced off the bottom and come a long way back, which is consistent with an improvement in the economy. The extraordinarily high yield paid by these bonds to reflect their default risk has been shrinking lately. I think the corporate mentality of the 1990s, which is to pay down debt and clean up balance sheets, will be healthy for high-yield bonds in general. Unfortunately, I think most of this good news has been recognized by the market and is incorporated in prices.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART CAPTION: IMPACT OF CHANGING INTEREST RATES ON MUTUAL FUND NET ASSET VALUES