This is likely to prove a challenging year for bond investors. But that doesn’t mean that there aren’t opportunities out there for the shrewd. Investors can take advantage of mispriced opportunities or dip into lower-rated bonds with solid fundamentals. Here are two bond funds that still have some upside. –The Editors

After the Federal Reserve purchased another $600 billion worth of Treasury notes as part of its second round of quantitative easing (QE2), investors pulled money out of Treasuries-focused funds and other bond offerings. This move reflected widespread concerns about a weaker US dollar and an uptick in inflation.

Although these fears are justified in light of QE2, there’s too much slack in the global system for inflation to spike dramatically in 2011.

Additionally, the Fed is unlikely to raise interest rates in the first half of 2011–another positive development for bonds–though the likelihood of a rate hike increases in the final six months of the year. US gross domestic product should grow 2 to 3 percent next year. Slow growth, coupled with persistently high unemployment, won’t provide much incentive for the Fed to boost interest rates.

At present, the biggest risk for bond funds is that money will shift toward growth-oriented investments as investors seek better returns.

This outlook suggests that readers should focus on stable fixed-income holdings.

Osterweis Strategic Income (OSTIX, 800-700-3316) was wildly popular in 2010, attracting more than $500 million in new investment, though inflows have tapered off thus far in 2011. The influx of new money has increased the fund’s cash position to roughly 15 percent of investable assets. Although managers Karl Kaufman and Simon Lee have always maintained a healthy cash allocation in their portfolio, the current level is a bit high compared to the historical norm.

This cash position, and a healthy allocation to convertible securities that perform more like stocks, weighed on the fund’s 2010 performance; the offering’s 10.1 percent return for the year ranked it into the 64th percentile of the multi-sector bond category.

Nevertheless, the fund’s long-term performance remains solid, ranking in the top 7 percent of its category. Kaufman and Lee have managed risk well, focusing on issues from companies that boast leading market positions and generate cash flows that support their debt obligations. The pair also tends to buy bonds with maturities of less than five years, reducing both interest rate and credit risk.

Although the fund’s returns may be anemic in the intermediate term, a 5.7 percent yield and management’s efforts to contain risk make it a key component of a balanced, total-return portfolio.

Northern Intermediate Tax-Exempt (NOITX, 800-595-9111) gave up some ground when municipal bonds sold off in the fourth quarter. But the weakness doesn’t stem from any fund-specific issues. Almost $40 billion worth of new municipal issues hit the market in December, leading to more supply than demand of municipal bonds.