While stockholders have gone on a roller coaster ride for the past couple of years, bond investors have been playing the more staid game of watching interest rates.

Rates have fallen, obviously, as the Federal Reserve pumped liquidity into the system. But that massive liquidity injection engineered by the Fed and other central banks in the wake of the financial crisis has to be withdrawn to forestall inflationary consequences.

The question now is when, not whether, the Fed will tighten. And that puts financial advisors in a quandary: How can they help clients minimize potential losses in fixed income portfolios when the Fed does raise rates?

The knee-jerk reaction that higher rates will be bad for bonds ignores the vast difference between risk-free Treasury issues-priced on interest rates alone-and high yield corporate bonds, which depend far more on the creditworthiness of the issuing company than interest rates. At a time when an economic recovery is taking hold, improving credit quality in the high-yield sector could easily narrow credit spreads over Treasuries to offset or even overwhelm the effect of any rise in rates. Most observers see rates moving up at a measured pace and by a smaller amount than in past cycles.

Bank of America Merrill Lynch, for example, does not expect the Fed to begin raising the target federal funds rate until early 2011, followed by small increments that will take the rate to 1% by the end of next year. "It is not a gigantic move," Martin Mauro, the firm's fixed income strategist, says. "The economy faces quite a few headwinds. The recovery in housing is sputtering, bank lending has not picked up and inflation expectations seem to be going down."

Investment-Grade Bonds

Although Mauro believes investors should always own some Treasuries as a hedge against declines in stocks, he recommends a reduced exposure to allow room for more corporate bonds, both high-yield (7% for investors with moderate risk tolerance) and investment grade (24%).

However, since the returns on high-yield bonds have a relatively high correlation to stocks-around 70%-they are not as good for diversification purposes.

"The factors that make high-yield bonds less likely to default are the same factors-higher profitability and cash flow-that make stock market performance better," Mauro says.

By definition, credit is not as important to the pricing of investment grade corporate bonds. Interest rates play a bigger part in their valuation, but with the yield curve as steep as it has ever been, a modest hike in short rates may not have much effect on longer rates. Mauro recommends that investors focus on bonds that mature in five to 15 years, avoiding shorter-dated paper that is most at risk when rates go up.

Echoing the belief that the Fed will move in small steps is Jeff Tjornehoj, research manager, U.S. and Canada, at Lipper, a mutual fund research and rating firm. Tjornehoj says it could take until the end of next year or beyond before the Fed funds rate hits 1.5% to 2.0%. He also sees room for the narrowing of high-yield spreads, but isn't convinced that high- yield bonds would outperform investment grade corporates and Treasuries on a risk-adjusted basis, especially if the economic recovery falters. "We could reverse the progress we've made in the last year or so if we enter a double-dip recession," Tjornehoj says. "We're certainly not out of the woods yet."

Corporate bonds (both investment grade and high yield) had a huge bull run over the past 12 months.

In fact, for a brief period in March, swaps on top quality corporate credits traded at rates that implied a lower yield than Treasuries of equivalent maturity. Tjornehoj contends that was a technical aberration. "No corporation can print money," he says. "They tend to discipline themselves more quickly than governments can." But, the flood of Treasury issuance needed to finance the bloated U.S. budget deficit may mean that investment grade corporates trade at tighter spreads than they have in the past.

High-Yield Bonds

Matt Toms, head of credit at ING Investment Management in Atlanta, believes that the recent recession has already purged the high yield market of the weakest credits. The default rate on high-yield bonds soared in the first half of 2009, then the tide turned in June 2009 after the month-by-month rate peaked. Finally, the rolling 12-month rate began to decline early this year. This cleansing paved the way for new issuance in the capital markets, allowing companies to ease liquidity pressures and roll over debt into longer maturities. "What is left is a vetted universe that has decent liquidity and a growing earnings base, catalysts that can fuel high-yield bonds to tighter spreads," Toms says. On an option-adjusted basis, high-yield spreads in early May were about 600 basis points over Treasuries, in line with the historical average.