The fourth quarter of 2010 was a sour time for bond funds. Long government funds lost 8.6 percent, and most other fixed-income categories sank into the red, according to Morningstar. The losses were caused by rising rates. During the quarter, the yield on 10-year Treasuries rose from 2.54 percent to 3.30 percent (despite the Fed's attempts to keep rates low).

Many economists argue that rates will continue rising as the economy recovers. If that happens, bond funds could struggle, and clients may blame financial advisors for disappointing fixed-income results.

To help manage risk, consider a breed of resilient bond funds. These sell short and use other techniques that can profit during periods of declining bond prices. The funds proved their mettle in the fourth quarter when they outperformed benchmarks by comfortable margins.

Among the steadiest choices is Driehaus Active Income (LCMAX). During the five years ending in November, Driehaus returned 6.2 percent annually, about the same results as the Barclays Capital Aggregate bond index. The fund was about as volatile as the benchmark, as indicated by standard deviation. So why bother with the actively managed fund? The reason is that Driehaus outperforms when rates rise.

Consider that the Barclays benchmark has a duration of about five years. So if interest rates rise by 1 percentage point, a Barclays index fund would lose about 5 percent. But Driehaus would not necessarily lose anything because the fund's portfolio managers aim to have a duration of zero. “We want to make money, regardless of the interest rate environment,” says portfolio manager K.C. Nelson.

Nelson limits duration by holding a mix of long and short positions. The manager favors pairs trades, going long a bond and short a security from the same industry. The fund often holds big cash positions. The strategy usually works, and Driehaus has made money in each of the past five years.

Junk in the Trunk

To own high-yield bonds, consider MainStay High Yield Opportunities (MYHAX). In difficult times, the fund can short up to 40 percent of assets. When bonds look promising, the managers can eliminate their hedges. The aim is to excel in up and down markets, and so far the young fund has succeeded. In 2008, MainStay lost 14.9 percent, outdoing 97 percent of its competitors. When markets rebounded in 2009, the fund returned 54.4 percent, roaring past 81 percent of peers.

Early in 2008, the fund had shorted 28 percent of assets, including bonds of Mexican homebuilders. The companies weren't necessarily in trouble, but the prices seemed rich and the yields puny considering the risk, says portfolio manager Michael Kimble. The shorts paid off as the market collapsed. These days the fund is bullish on high-yield bonds. Kimble says that the annual default rate should drop below 2 percent this year, down from a high of 14 percent during the recession.

Though Kimble is not overly worried about default risk of high-yield bonds, he is concerned that rates will rise. To protect shareholders, he is shorting 10-year Treasury bonds. “We have taken some of the interest-rate risk out of the portfolio,” he says. “If rates rise, we should outperform a conventional high-yield fund that doesn't short.”

Another high-yield choice is Iron Strategic Income (IFUNX), which has returned 11.1 percent annually during the past three years, outdoing 98 percent of peers. The fund can use a variety of techniques, including selling short and holding cash. The portfolio managers can also buy puts, options that increase in value as bond prices fall. In 2008, the fund held cash and only had 20 percent of assets in long high-yield positions. These days the long exposure is above 90 percent.

Besides holding individual bonds, the portfolio can also include mutual funds and ETFs. Iron Strategic now has most of its assets in a dozen mutual funds, including Fidelity Advisor High Income (FHIAX) and Artio Global High Income (BJBHX). “The bid-ask spreads on ETFs and individual bonds can be relatively high,” says portfolio manager Aaron Izenstark. “The expense ratios on the institutional class shares of the mutual funds are so low that they can be the cheapest way to get exposure to the high-yield market.”

To protect against future rate increases imposed by the Federal Reserve, consider holding a world bond fund. Foreign markets don't always move in lockstep with the Fed. So when Ben Bernanke next raises rates, overseas central banks may be holding steady. A solid performer is Loomis Sayles Global Bond (LSGLX), which has returned 8.8 percent annually during the past 10 years, outdoing 88 percent of competitors.

Bottom Fishing

Loomis Sayles roams the world in search of undervalued bonds. During 2008, the fund had half its assets in corporate bonds, which had suffered big price declines. Now that markets have revived, the portfolio only has 30 percent of assets in corporate issues, with the rest in government bonds and cash.

The fund emphasizes bonds from countries with strong currencies, including Norway, Canada, and New Zealand. A rise in currencies boosts the value of foreign bonds for U.S. investors. Portfolio manager David Rolley is underweight the dollar and euro because deficit problems could undermine the currency values.

He is particularly keen on bonds from fast-growing Asian markets, including Korea, Indonesia and Singapore. “Those countries are benefitting from exports to China,” says Rolley.

Among world bond funds, a strong performer has been Eaton Vance Global Macro Absolute Return (EAGMX), which returned 1.7 percent in 2008, while its average peer lost 1.6 percent. The fund recently closed to new investors, but the company has launched a new fund, Eaton Vance Global Macro Absolute Return Advantage (EGRAX). The two funds follow a similar strategy, though the new fund takes a somewhat more aggressive approach. The Eaton Vance managers short bonds that are richly priced or seem about to default. The funds often take currency positions, owning holdings that seem likely to appreciate. The portfolio managers recently shorted the euro and went long on Swedish krona.

Portfolio manager John Baur likes some foreign bonds because of their high yields. He favors short-term Egyptian government bills, which yield around 8 percent. “Even if the currency doesn't appreciate, the yield on the position makes it worthwhile,” he says.