By Jon Birger

(MONEY Magazine) – The bond market is always confusing, but these days it's sending more mixed signals than ever. An improving economy typically means a higher risk of inflation and greater demand for loans. Those factors generally lead to higher short- and long-term interest rates. That, of course, is bad news for bonds, since bond prices move in the opposite direction of rates. Yet despite the now almost universal belief that rates will rise in 2004, long-term bonds have actually rallied since last summer. It just goes to show that bond yields aren't always a function of prevailing sentiment among bond traders. As long as Asian central banks are still gobbling up Treasury debt and corporate America isn't issuing many new bonds, interest rates are going to fall and it doesn't matter what bond traders think. Yet it's a pretty safe bet that a rise in rates is coming, given inflation concerns, anticipated increases in corporate borrowing and a widening trade gap (which weakens the dollar and dampens foreign investors' appetite for Treasury bonds). Joe Veranth, a portfolio manager with Dana Investment Advisors, is betting on a one-percentage-point increase in 10-year Treasury yields, now 4.35%. Sounds about right to us, which is why we wouldn't be rushing to put money into bonds with maturities of five years or longer. On the other hand, a stronger economy should translate into improved credit quality for corporate and municipal bonds, making them solid bets. Two funds to consider are Vanguard Short-Term Corporate, which offers a low 0.23% expense ratio and a 20-year record of superior returns, and Evergreen High Income Municipal, whose high-yield focus is less vulnerable to rising rates, as junk bonds tend to do well in a reviving economy. --JON BIRGER