(MONEY Magazine) – If popularity were the same as profitability, bond funds would surely be the best investment since the Yankees bought Babe Ruth from the Red Sox for $100,000 in 1920. The funds already hold more than half a trillion shareholder dollars, $35.3 billion more than money markets and $111 billion more than equity portfolios. And with banks now paying depositors 3% or less, refugees from CDs and savings accounts keep streaming in. During the first two months of 1993, investors dumped $1.7 billion each week into taxable bond portfolios and a staggering $1.2 billion weekly on tax-exempts -- the latter spurred, no doubt, by Clintonoia, the fear of tax hikes. But sometimes all those people can be wrong -- or at least overly enthusiastic. Like the mighty Babe -- who, after all, struck out twice for every home run he hit -- bond funds have a history of disappointing fans who expect too much. ''Too many investors focus only on getting a high yield,'' warns Steven Enright, a financial planner in River Vale, N.J. ''They end up taking bigger risks than they realize.'' Indeed, the last time bond funds were as popular as they are today was in 1987, just before a vicious midyear sell- off cost long-term bond funds 7.5% in a few months. Still, if you understand their risks, bond funds are a great way to pull in steady income. Ken Jessen of Loveland, Colo., for example, commits 56% of his $82,000 portfolio to bond funds and uses the dividends to help pay for his sons' post-secondary schooling. The 54-year-old engineer, who is profiled opposite, also keeps 36% of his mother Vivian's money in bond funds to generate cash to cover her $2,433 monthly nursing-home care. But bond funds aren't just for income seekers. Their other key role is to reduce the volatility of your total portfolio. ''Bonds make it possible to tolerate the risks of equities,'' explains Roger Gibson, a Pittsburgh investment adviser. ''When stocks plunge, bonds tend to fall less far.'' Sometimes they even rise: According to the Chicago investment research firm Ibbotson Associates, in 15 of the past 20 years when stocks lost money, long- term bonds had gains averaging 5.5%. Before you start picking funds, though, understand that funds aren't always the most economical way to put bonds into your portfolio. If the only bonds you plan to buy are supersafe Treasury securities, you may be better off getting your quota direct from Uncle Sam. For tips on when and how to buy your Treasuries from the source, see page 118. If you decide that bond funds are your best fixed-income choice, you'll find MONEY's list of 65 superior selections in the tables on pages 92 to 95. But before you let your fingers do the toll-free walking, avoid the mistake of assuming that today's bonds (and the funds that hold them) are the sleepy little numbers your grandfather prized. Far from it. Like every other kind of fund, bond funds require you to make sophisticated trade-offs between risk and reward. So you need to understand not only how bond funds work and what they can do for you but also what can go wrong.

It's total return that counts The first thing many investors look for in a bond fund is a high current yield. Big mistake. For one thing, the 8% payouts that some aggressively managed funds now brag about owe more to accounting sleight-of-hand than investment brilliance (see the box below). Besides, an 8% yield gives you no advantage over CDs if the value of your shares simultaneously skids by 5%. What really matters is your fund's total return -- its income and gains distributions plus (or minus) any change in net asset value. Overwhelmingly, two factors cause swings in a bond fund's share value: credit risk and interest-rate risk. The former measures the likelihood that the issuers of the fund's bonds will default on interest or principal payments. The risk is zero, for example, for bonds backed by the U.S. Government and low for those issued by solid corporations like General Electric and Minnesota Mining & Manufacturing. It's substantial, on the other hand, in a fund like Northeast Investors, where the investment taste runs to relatively wobbly credits like Stone Container and Reliance Group Holdings. Shareholders in such a portfolio collect a generous yield (ordinarily 3.5 to 4.5 percentage points above that of 10-year Treasuries, or about 9.5% these days) that they hope will more than offset occasional defaults. In fact, the default rate for such high-yield or junk bonds runs about 3% a year, according to a Salomon Bros. study.

Interest-rate risk is a less obvious and more pernicious peril. It's based on a sort of Newtonian Law of the bond market: When interest rates rise, prices of outstanding bonds fall. That's because potential buyers of previously issued bonds demand price cuts to compensate them for the old bonds' lower yields. Of course, the process also works in reverse. When rates fall, previously issued bonds become more valuable and their prices rise, since they're now the ones with the comparatively loftier yields. As a rule, a bond's sensitivity to interest-rate moves decreases as it approaches maturity. That explains why so-called short-term bond funds like T. Rowe Price Short- Term Bond, whose average bond matures in roughly 2.4 years, have as little as 20% of the volatility of a long-term rival like Vanguard Fixed Income-Long- Term Treasury, where the average maturity is 21.7 years. If interest rates rise one percentage point from current levels -- a prospect some economists rate a 60-40 shot over the next year -- the T. Rowe Price short-term fund would lose 1.9% of its share value, the long-term Vanguard entry, 9.7%. Interest-rate risk explains another oddity of bond funds: Most of them are strongest when the economy is weak. That's because economic slowdowns tend to reduce loan demand and dampen inflation. Both factors tend to push interest ( rates down and, hence, drive bond prices higher.

How much to put in bond funds Many financial advisers suggest that you build your bond fund portfolio around a conservative core. You might begin your search by investigating the 12 funds in the short/intermediate-term taxables category on our all-star roster. Two of the best over the past five years to April 1: USAA Intermediate (up an annually compounded 8.8%) and Dreyfus Short-Intermediate Government (up 6.9%). Why the short and intermediate funds? Explains Theresa Havell, director of fixed income at the fund group Neuberger & Berman: ''Five-year Treasuries have yielded 96% as much as a 30-year T-bond with less than 50% of the interest- rate risk.'' As your bond portfolio grows, you can add funds of different maturities or credit quality, depending on your market outlook and risk tolerance. For example, had you foreseen the one-percentage-point interest-rate decline in the last half of 1991, you could have snared capital gains of 7% by diversifying into a long-term fund. (That may not be such a good idea today, though.) But don't go fund crazy. Says Philadelphia financial planner Neil Kauffman: ''You can diversify properly with just two or three funds.''

Comparing bond fund categories Once you know how much of your portfolio will go into bond funds, you need to focus on the fund categories that best suit your goals. Here's a rundown of your choices: U.S. Governments. These funds invest in bonds issued by the U.S. Treasury or federal government agencies. The safety from default is all but absolute, making government funds tops for conservative income seekers. But the trade- off is a lower yield: Vanguard Fixed-Income U.S. Treasury Long-term, for example, recently paid 6.9%, vs. 7.2% for Vanguard Fixed-Income-Investment Grade, a corporate fund of comparable average maturity. (In Treasury-only funds, the lower yield is at least partly made up by the fact that the dividends escape state taxes, except in Pennsylvania.) Be aware too that government backing does not protect you against interest-rate risk. A Treasury portfolio will drop in price when interest rates rise. One species of government fund specializes in mortgage-backed securities, which represent shares in investment pools consisting of home mortgages. They're backed by federal agencies bearing quaint nicknames such as Ginnie Mae (the Government National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation). They offer yields 0.5 to 1.5 points higher than those on Treasury funds (or 6.9% vs. 6.4% lately). The higher yields are partly a trade-off for a risk peculiar to mortgage- backed securities: prepayment. When interest rates fall, homeowners rush to refinance their mortgages at lower rates. As the old pooled mortgages are paid off, funds holding the securities are, in effect, handed back parts of their principal, which they then must reinvest at lower prevailing yields. As a result, mortgage funds get a far smaller boost than Treasuries from falling rates. Corporates. Corporate bond funds allow you to invest in businesses ranging from America's most solid to its shakiest. Typically, though, funds in MONEY's high-grade corporate category (recent yield: 7.2%) hold bonds carrying an average credit rating only a step below governments, making them an appealing alternative for investors who want to earn more than government funds pay but who don't want to get swamped by credit risk. ''Too many investors prefer the apparent safety of federal backing,'' says John Rekenthaler, an editor with the mutual fund research firm Morningstar, ''but over the long term, high- quality corporates will give the better performance with only slightly more credit risk.'' Indeed, over the past 20 years, high-grade corporates have returned 9.5%, compared with 9.1% for U.S. Governments. At the other end of the credit spectrum are high-yield corporates, better known as junk bond funds. They specialize in the bonds of debt-burdened behemoths like Chrysler or unproven start-ups like Hollywood Casinos. Unlike other bond funds, junkers are at their best in a strengthening economy, since a healthy business climate reduces the risk of defaults. Indeed, during the current recovery, junk has been one of the hottest bond categories, up 15.7% on average over the past 12 months. But with the spread between Treasuries and junk funds at about 3.5% -- the low end of their range -- high-yield issues don't have much room to recreate the glory days of recent years. Junk fund managers predict a still respectable return of around 9% this year, as long as the economic recovery stays on track and yields on competing high-quality bonds don't spike up. Tax-exempts. Tax-exempt funds buy bonds issued by cities, states and other local government entities. Also known as municipal bond funds, all of them produce dividends free of federal income tax. The dividends from so-called / single-state muni funds, which invest entirely within the borders of one state, are exempt from state and local taxes as well for resident shareholders. Muni funds are enticing today, even before figuring in the higher tax brackets that President Clinton has promised. Intermediate-term tax-exempts, for example, recently paid an average of 5%. If you're in the 28% bracket, that's equivalent to 6.9% on a taxable fund, at a time when the average high- grade intermediate taxable fund yields just 6%. (To learn how to calculate the taxable equivalent for any muni yield, see the box on page 89.) Analysts say that a growing appetite for tax-frees and a shrinking supply also bodes well for muni prices. ''Aging baby boomers will increasingly need to save on a tax-sheltered basis,'' argues Ian MacKinnon, head of fixed-income investing at the Vanguard Group. ''Meanwhile, hundreds of billions of dollars' worth of bonds will be taken off the market over the next three years as municipalities retire the high-income bonds they issued in the early 1980s.'' But you still need to be cautious. Unless otherwise stated in the prospectus, most muni funds hold longer-term securities than comparable corporate or government funds, making them more sensitive to interest-rate fluctuations. Also, check the fund's annual report to make sure that it isn't trying to pump up yield by buying the bonds of revenue-strapped states like California and New York or by loading up on the offerings of frequently shaky muni issuers like industrial development agencies or hospitals. Analysts say that the slight increase in yield (normally three-tenths of a percentage point or so) isn't worth the considerably greater default risk. All of the tax-free funds on our best-buy roster diversify widely and keep their portion of low- rated debt to 30% or less of the portfolio. Credit risk is especially important if you're considering a single-state fund. If your state runs into budget problems, the fund has nowhere to hide and your shares could be hammered. So if a single-stater makes sense for you, stick with funds like Vanguard Pennsylvania Tax-Free Insured-Long-Term, where interest and dividend payments are backed by commercial bond insurers. Even then, the fund should offer an after-tax yield advantage of at least half a percentage point over comparable national munis to justify the extra risk.

Picking the right portfolio Once you've narrowed your search to one or two types of bond funds, you can % begin to weigh individual portfolios. Here's what to look for: Duration. As mentioned earlier, funds holding long-term bonds are hit hardest when interest rates rise, and gain the most when they fall. But other factors can cause funds to be more or less rate-sensitive than their maturities would lead you to believe. Benham Target 2000 and Dreyfus 100% U.S. Treasury Intermediate, for example, have identical average maturities of seven years, but the Benham fund is 40% more volatile. That's because it specializes in extremely rate-sensitive zero-coupon bonds -- those in which the return consists entirely of price appreciation. To judge interest-rate risk more accurately, professionals use a measure called duration. To calculate it, managers weigh a number of factors besides maturity that could affect a bond's response to interest-rate moves. Among them: the size of a bond's interest payout and the likelihood of early redemption. The result is often stated in years. ''As with maturities, the higher the duration, the more sensitive the issue,'' says James Midanek, portfolio manager at Montgomery Securities. ''But duration tells you the impact more precisely.'' For instance, if rates move up (or down) by one point, Scudder Income, which has a duration of six years, will lose (or gain) 6%. Morningstar has calculated duration for all the picks in our table. Credit quality. You can get a good idea of a fund's default risk by noting how its holdings have been graded by rating agencies like Standard & Poor's. Our tables tell you what percentage of each fund's portfolio rates at least an AA (one step below Treasuries) or at least a BBB (the bottom rung of investment grade). For example, Strong Short-Term Bond has only 26.4% above AA but 72.7% between AA and BBB. That reflects manager Bradley Tank's taste for medium-grade issues. Consistency. As with stock funds, consistency is an important key to bond fund performance. The consistency ratings in the table will tell you how a fund stacked up against its peers in each of the past five calendar years. A rating higher than 50 for long-term bond funds and 30 for short/intermediate funds is a sign of a solid performer year after year. Also take a look at the fund's risk-adjusted grade, which reflects a fund's returns relative to its risks. One note: The rapidly falling interest rates of the past few years favor long-term funds in our grading system; so if you're looking for a short- or intermediate-term fund, don't be put off by a low MONEY grade. Expenses. Because bonds in the same investment category tend to react in unison to interest-rate moves, it's difficult for a bond manager to get an edge on the competition by superior bond-picking skill. As a result, no-load funds with annual expense ratios below the bond fund average of 0.9% have an often insurmountable head start on their peers. (See ''Buying Funds at Bargain Prices'' on page 27.) One exception: high-yield bond funds, in which a fund manager's skill has greater impact than in the more homogeneous high-grade market. Even with junk funds, though, it's good policy to lean toward no-loads with expense ratios below the category average of 1.5%. High fund expenses may carry hidden costs as well. Managers may be tempted to compete with their less expensive peers by taking more risks. For example, with an expense ratio of 1.42%, MFS Government Income Trust Plus (since renamed MFS Government Mortgage) tried boosting its yield with options and futures from 1987 through 1992, a losing gambit that landed it near the bottom of the Ginnie Mae heap.

Market outlook. MFS' poor showing aside, bond fund investors have profited from taking risks recently. But no bull market lasts forever. With yields on 30-year Treasuries at a 16-year low and the economy picking up steam, analysts say you should think twice about buying long-duration funds. ''Now is a time for fixed-income investors to play it safe,'' declares Theresa Havell of Neuberger & Berman. ''If you want to take chances, do it with stocks.''

CHART: NOT AVAILABLE CREDIT: Sources: Lipper Analytical Services, Micropal Inc., Morningstar Inc. and the funds CAPTION: THE 65 BEST BOND FUNDS TO BUY NOW Yearning for yield? Check out this list of 65 top funds. All have posted superior long-term total returns in the past; and since low costs are the best predictor of future performance, we included only no-loads with modest expense ratios. Your best bet now: an intermediate fund, which offers 96% of the gains of long-term portfolios with only half the risk.