The Great Bond Bear Why the world's best bond investor isn't even bullish on his own fund, and what you should do about it
By Penelope Wang

(MONEY Magazine) – With $75 billion in assets, Pimco Total Return ranks as the world's largest bond fund and is a staple of 401(k) plans. So it was news when manager Bill Gross told the New York Times in January that he had yanked some of his own money out of the fund. Why? Gross expects bond prices to drop as investors--looking at spikes in the deficit and government spending--bet on a return of inflation and high interest rates. In other words, Gross does not see much opportunity to make money in his own fund.

Gross has a superb track record. So shareholders in Pimco Total Return and, for that matter, investors in any other bond fund, have to be asking themselves, should I follow Bill to the exits? We think the answer is yes--but only with some of your money. Gross' bear call is a reason to fine-tune your portfolio, not overhaul it.

First let's take a closer look at what Gross is actually doing with his money. A Pimco spokesman was quick to stress that Gross isn't bailing out of Pimco Total Return altogether. He still owns shares. But he has been shifting his "personal tactical money" into a variety of investments poised to do well in the event of an inflation scare: commodities, foreign bonds and real estate, as well as leveraged closed-end muni funds. (For more on inflation hedges, see Michael Sivy's column on page 57.) A relatively plain-vanilla fund like Pimco Total Return, which is designed to be the core fixed-income holding for most of its investors, can't venture far into such alternative investments.

That doesn't mean Gross has left his shareholders twisting in the wind. He's made the Total Return fund considerably more conservative, notes Morningstar fund analyst Eric Jacobson. Last year, Gross shifted about 40% of the fund's assets into short-maturity bonds. These hold up better than intermediate or long-term debt when rates rise. He has also stashed 9% of assets in inflation-protected Treasuries, or TIPS, which pay out more income as inflation rises. Despite these conservative strategies, Gross led Pimco Total Return to a healthy 5.1% return in 2003. Bottom line: Even if all of Gross' direst predictions come true, Pimco Total Return isn't likely to lose a lot. So there's no need to panic.

But don't just sit there. You may as well avoid losses, even slim ones, where you can. And Gross' revelations also point to some new opportunities. Bond fund investors--in Pimco or not--should consider these moves:

CUT BACK ON BONDS Many investors have seen their bond fund allocations climb over the past few years, simply because bonds have outperformed stocks. Others, burned by the stock market, have sought shelter in bonds. It's time to regroup. "Bonds are no longer a safe haven, and stocks are likely to deliver better returns in an improving economy," says Andrew Clark, senior research analyst at Lipper. So trim your bond holdings to restore your original allocation; you might even move an additional 10% of your bond stake into stocks, depending on your tolerance for risk and need for income.

GO SHORTER--BUT DON'T OVERDO IT "It makes sense to shift some of your bond assets to short-term bond funds or even money-market funds," advises Bob Auwaerter, Vanguard's head of fixed income. "Especially if it's money you might need in the shorter term." For your long-term money, however, keep a position in an intermediate-term fund like Gross'. As rates rise, your reinvested dividends gradually buy higher-yielding bonds. Over the long term, studies show, by reinvesting at higher rates you end up with a better total return than you would have received if rates stayed flat.

TAKE TIPS Like the name says, inflation-protected bonds offer shelter from rising prices. Put 10% of your bond allocation in TIPS, preferably in a 401(k) or IRA. If you own Total Return, Gross has done it for you. If not, look at Vanguard Inflation-Protected Securities (800-851-4999) or Fidelity Inflation-Protected Bond (800-343-3548).

VENTURE ABROAD Foreign bonds have been delivering higher yields than U.S. debt. And the falling dollar has boosted the returns of non-dollar-denominated issues. So in addition to a core fund like Total Return, consider holding 10% of your bond stake in a foreign fund such as American Century International Bond (800-345-2021).

HOLD HARD ASSETS In general, investors should keep 10% of their overall portfolio in a real estate or REIT fund, such as Cohen & Steers Realty (800-437-9912) or Third Avenue Real Estate Value (800-443-1021). These funds hedge against inflation and perform out of sync with stocks, adding to diversification. If you don't already own one, it's a good time to buy. You might also put 5% of your equity stake in a commodities fund. Our top choice is T. Rowe Price New Era (800-638-5660), which invests in everything from oil producers to gold miners. --PENELOPE WANG