Federal Pressure

As the economic picture continues to improve, the Federal Reserve will find itself under increasing pressure to increase rates and scale back the easy money policies of the past two years. Fixed-income investors will need to shift gears and shore up their portfolios with a variety of bond types and credit qualities. Here are two funds that will continue to perform when interest rates head higher.

Heading into 2010 the dollar strengthened, as employment numbers improved and US economic activity ticked up. At the same time, Treasury futures began to signal that a rise in the Federal funds rate might be more imminent than many investors are banking on.

Here are two funds that can help you prepare the fixed-income portion of your portfolio for the inevitable rate hike.

Janus Flexible Bond (JAFIX) invests in a fairly diverse collection of bonds, ranging from government debt and government-backed mortgage-backed securities (MBS) to quality corporate issues and a smattering of high-yield offerings. However, managers Darrell Watters and Gibson

Smith avoid more esoteric territory such as currencies and nongovernment MBS.

Benchmarking against the Barclays Capital US Aggregate Bond Index, management relies on a bottom-up approach to bond selection. Although Watters and Smith’s analysis of the macro environment guides them to the most attractive point on the yield curve, the security selection process involves rigorous analysis of individual companies.

Management also takes a value approach to bond selection, looking for companies that are working toward improving their credit ratings rather than just their share prices. This strategy has produced a diverse portfolio that includes AutoZone, Sprint Nextel and International Game Technology.

This approach has paid off for investors; the fund has outperformed its benchmark over the past 12 and 36 months, returning 16.2 percent and 8.1 percent, respectively. These one-year results best the index by over 6 percent and push the fund’s three-year lead to almost 2 percent. On a three-year and five-year basis, that performance ranks the fund in the top 10 percent of intermediate-term bond funds.

As spreads have tightened, Watters and Smith have transitioned away from government MBS, which made up almost 20 percent of the portfolio in early 2009, to less than 1 percent. The duo has also scaled back the fund’s exposure to Treasury issues in favor of a select group of high-yielding corporate issues.

Osterweis Strategic Income (OSTIX) is much more diversified both in terms of credit quality and sector investment, as managers Carl Kaufman and Simon Lee scour the debt universe for undervalued plays. Currently almost half of the fund’s assets are invested in long-term, high-yield securities, otherwise known as junk bonds. But that shouldn’t worry investors; Kaufman and Lee are seasoned veterans who have oodles of experience in the wide world of bonds.

The remainder of the fund’s portfolio is a mix of equity-sensitive convertible issues, whose value moves with stock prices, and bust convertibles, which trade in traditional bond-like fashion. Throw in a smattering of floating rates and short-term bonds, and you have a strategy that produces results: On a five-year basis, the fund’s returns place it in the top 7 percent of Morningstar’s Multi-Sector category.

Management has done an excellent job of evaluating and managing credit risk, which limits blowups but can drag on returns when better-quality bonds outperform.

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