(MONEY Magazine) – You may notice something missing from the MONEY 100, the elite list of our favorite funds that begins on page 66: There are no bond funds. That's not because there aren't any good ones; it's because there aren't many. In fact, there are only a few worth bothering with at all.

We'll get to them in a minute. But first, I know what you're thinking: Bond funds are for boneheads. The average diversified U.S. stock fund has earned nearly 27% annually in the past three years, turning $1 into $2.03. Meanwhile, government bond funds have gone up less than 8% annually, nudging $1 up to just $1.24. Chickenfeed! And despite those piddling returns, bond funds seem deviously risky: If interest rates rise, bond funds plunge.

But are bond funds really so bad?

BONDS SMOOTH THE BUMPS

The first reason people overlook bond funds is because they're made up of bonds. But bonds didn't look so bad from 1969 to 1982, when the 7.8% annual average return of medium-term U.S. bonds surpassed the 6.7% average gain of U.S. stocks. No surprise, then, that back in 1982 many investors were selling stocks to buy bonds. Guess what: 1982 began the biggest bull market stocks have known. Just as you would have been wrong to put all your money in bonds in 1982, when stocks were stone cold, so I think you'd be wrong to put all your money in stocks today.

The bulls are still running, of course--but that can't last forever. Listen to Robert Rodriguez, who runs both FPA Capital, an outstanding stock fund, and FPA New Income, a great bond fund: "It's not a question of if--it's a matter of when the stock market will enter a period of substandard returns."

Even if stocks keep booming, bonds can smooth the bumps. Over all five-year periods since 1976, bonds have moved in sync with stocks less than a third of the time. In the murderous month of October 1987, stocks lost 21.5% of their value, but medium-term bonds rose 3%. In 1973 and 1974, when stocks fell 37.2%, bonds went up 10.6%. As stocks zigged, bonds zagged--providing a cushion when investors needed it.

BOND FUNDS BEAT BONDS

Conventional wisdom says bond funds are bad for a second reason: In almost every case, you have no assurance of getting your money back. If you buy a bond fund and interest rates rise, your net asset value will crash. But if you buy an actual bond, you can simply hold it to maturity and get your money back (barring the unlikely event of a default), no matter how much rates skyrocket.

As it so often is, the conventional wisdom is wrong. Individual bonds are better than bond funds only if you can invest, say, $100,000 a pop. For the rest of us, bond funds with low expenses beat individual bonds hands down.

Here's why: the power of compounding. True enough, any rise in interest rates will temporarily depress the fund's value, as investors learned to their shock in 1994, when a jump in rates knocked the average bond fund for a 4% loss. But in the long run, higher rates mean a fund's income can be reinvested at greater yields.

Let's say you invest $1,000 in a new 30-year Treasury bond at 6%. Between now and 2028, you'll get $30 in interest every six months. Now let's say interest rates rise one percentage point. If you put each of your bond's interest payments into an investment yielding the new rate of 7%, you'd actually earn 6.54% annually over the life of your 6% bond.

Here's where being a small investor is a big problem: The interest payments on your bond are only $30 apiece, and no one will sell you a bond for a lousy 30 bucks. Instead, you'll have to put your little nubbins of interest into the bank or a money fund, where they're likely to earn far less than the rate on new bonds. And thus you fail to harness the full power of compounding.

But a good fund manager will sweep together all the interest payments and reinvest them in bulk purchases of new, higher-yielding bonds. No wonder Daniel Fuss, manager of Loomis Sayles Bond Fund, says, "I'd much rather have interest rates go up than down."

BONDS BOUNCE IF YOU DON'T

Bond funds also provide a more subtle form of protection. "Many investors," says Harvard economist John Campbell, "are unaware that their financial portfolio is dwarfed by the value of their human capital," by which he means their current and future job income. Most people's labor earnings are dependent on the health of the U.S. economy, since even a mild recession retards salary growth and a bad recession puts people out of work.

I'm a perfect example of what Campbell is talking about: As a financial writer, my income is captive to the health of the stock market, so I keep about 25% of my portfolio in bond funds to help reduce that risk.

Unless you're a minister, a mortician or a prison guard, your job income is probably tied to the stock market more closely than you think. Therefore, says Campbell, "if your labor earnings move with the aggregate stock market, you should take less risk in your financial portfolio." That means putting some assets in bonds or bond funds--preferably while stocks are still rising.

Picking among more than 3,700 bond funds, however, is a chore. Most just aren't worth bothering with, and many are carbon copies, especially those in the same sector. While one technology stock fund might buy Microsoft and another Netscape, nearly all medium-term Treasury funds use the same shopping list: U.S. debts due in 3? to six years. If you've seen one five-year Treasury, you've seen them all.

That's why I favor bond funds that keep costs low, since that's the easiest way to amplify returns. I also look for funds that invest in the backwaters of the bond market. Here are my favorites:

American Century-Benham Inflation-Adjusted Treasury (800-345-2021): This fund invests at least 65% of its assets in "inflation-protected" U.S. Treasury bonds, or TIPs. First issued last year, TIPs pay fixed interest (lately around 3.75%) that is automatically increased by the current inflation rate. Harvard economist Campbell lauds TIPs as the best way to hedge the risks of your human capital, since they virtually assure you of a positive return no matter how the economy fares. Run by David Schroeder, this fund charges just 0.58% in annual fees.

FPA New Income (800-982-4372): Robert Rodriguez is the junkyard dog of bond managers, dining on the stuff other investors leave for dead. In the late 1980s, Rodriguez latched onto convertible bonds issued by distressed high-tech companies. In 1994, he feasted on mortgage derivatives that had splattered after interest rates rose. Scavenging has its rewards: New Income hasn't lost money in any year since Rodriguez took over in 1984, and it has beaten more than 90% of its peers. The fund carries a 4.5% sales load, but its 0.59% annual expenses help compensate.

Fidelity Spartan High Income (800-544-8888): Spartan makes other junk bond funds look like garbage, beating 99% of them for the past decade. Manager Tom Soviero, two years at the helm, has kept the fund out in front with a canny bet on telecommunications bonds. Because their high yields make up for the occasional bust, junk bonds are less risky in the long run than they sound. This fund, with 0.8% in expenses, gives the biggest bang for the junk bond buck.

Fremont Bond (800-548-4539): Manager William Gross oversees more than $100 billion in bonds for endowments and pension funds. Gross runs this little fund in the same gutsy style he uses for the big boys. Last year, for instance, he put roughly 60% of assets in mortgage-backed securities--more than twice their weight in the Lehman aggregate bond benchmark--on the correct assumption that interest rates would not overheat. Over the past three years, Fremont has beaten 93% of all bond funds.

Heartland Short-Duration High-Yield Muni (800-432-7856): Here's the place to park some cash and still have a good return after the IRS whacks you. Managers Tom Conlin and Greg Winston buy municipal bonds that tax-free money funds consider too long term and intermediate muni funds consider too short term. "We shouldn't be able to buy bonds this cheap," says Conlin, "but nobody else wants them." While the fund's unrated bonds make it riskier than a tax-free money fund, it has returned a handsome 7% over the past year. Expenses run at 0.75% annually.

Loomis Sayles Bond (800-633-3330): Unlike most bond managers, Loomis Sayles' Daniel Fuss doesn't try to predict interest rates. Instead, his fund is a teeming grab bag of cheap bonds. He has owned debt issued by a Swedish maker of ball bearings and the Malaysian national phone company, as well as bonds from a South African utility, Rockefeller Center, the governments of Ecuador and Poland, and California's Orange County--after it went bankrupt. Fuss' portfolio has beaten 99% of all long-term bond funds, compounding at more than 14% annually since its 1991 launch.

Vanguard Bond Index-Total Bond Market (800-851- 4999): This fund (and its three siblings, which segment the U.S. bond market into short-, medium- and long-term) lives by rigorous logic. Over time, Vanguard's index funds finish miles ahead of most rivals, mainly by cutting costs to the bone. Their annual expenses of 0.2% are less than a fourth the average. Vanguard's huge size also enables it to buy in bulk and capture fleeting inefficiencies in prices. Over the past five years, Total Bond Market has beaten 70% of all medium-term funds, while taking an amazing 75% less risk.

Vanguard Municipal Intermediate-Term (800-851- 4999): This tax-free portfolio--complete with Vanguard's customary skinflint expenses of 0.19%--has pushed beyond 90% of its peers over the past decade. The fund holds down the notoriously high trading costs of tax-free bonds by trading a fourth as often as its peers. Manager Ian MacKinnon's judicious bets on the direction of interest rates have been right more often than not. The fund sticks strictly to high-rated bonds whose interest is free from federal tax.