There's no joy in junk bonds

In a panic, "high-yield backs off even faster" than investment-quality bonds, Auwaerter continues. "Normally, when you have a sharp spike in rates, investors want to go to high-quality paper, and high yield can suffer in that environment."

High-quality bonds are just as subject to duration risk as low-quality bonds, however, so they're no place to hide.

The average long-term government bond fund, which most fixed-income investors regard as the safest type, has a duration of 11.2 years. If Gross is right, their value will decline 16.8%.

American Century Target Maturity 2025 (BTTRX), such a fund, declined 2.1% last Thursday, 2.85% last week and 8.4% in the most recent three months. Year to date, it was down 4.9%.

The average intermediate-term fund, such as iShares Lehman Aggregate Bond (AGG, news, msgs), which I own in my model exchange-traded-fund portfolio, has a duration of 4.6 years and would plunge 6.9% if rates spurted a point and a half. The total return of such a fund in the past five years has averaged 4.7%, meaning future returns are likely to be negative.

Ultrashort bond funds, however, have minuscule duration risk. My favorite in this category, Schwab YieldPlus Select (SWYSX), has a duration of 0.4 years. And since it is constantly buying bonds to replace those that mature, its yield, which is currently 5.4%, would go up amid higher rates.

Schwab YieldPlus Investor (SWYPX), an identical fund with a lower required minimum investment, is yielding 5.25%.

A stay on the sidelines

Global monetary authorities are raising interest rates to combat inflation. High demand ultimately leads to higher wages, which lead to higher prices. China and India have been a fount of low-cost labor for more than a decade, but wages have begun rising there.

Already in the United States, the inflation rate is running higher than the Federal Reserve's announced comfort level of 1% to 2%. Raising interest rates, which is the cost of borrowing, will lead to less borrowing and thus to slower growth. That has already happened, with a vengeance, in the mortgage market.

As a matter of fact, last week's panic in the fixed-income marketplace was caused by massive sudden borrowing to hedge mortgage bonds. Elsewhere in that small-print bond warning is the explanation: Higher interest rates lead to higher duration for mortgage bonds because refinancings dry up.

This is a truly vicious cycle. "As mortgages are extending their maturities, the banks that own them will turn around and short Treasurys to offset that average maturity extension," Auwaerter explains. "Which in turn causes rates to go up, which in turn makes mortgages extend more, which means they have to do more hedging."

This is something you have to wait out, and the place to stand is the sidelines. In recent weeks I have eliminated my core personal bond holding, Harbor Bond Institutional (HABDX), in favor of ultrashort funds, including money markets.

Meet Tim Middleton at the Money Show

MSN Money's Tim Middleton will be among the dozens of renowned money experts, advisers and analysts sharing their wisdom in free workshops at The Money Show in Washington, D.C., Sept. 6-8. You'll also have a chance to network with fellow market enthusiasts, exchange investment ideas, share your experiences and enjoy the fellowship of like-minded investors. Admission is free for MSN Money readers. For complete details or to register for free admission, visit The Money Show Web site or phone 1-800-970-4355 (be sure to mention priority code #007417.)

At the time of publication, Tim Middleton didn't own any securities mentioned in this article.

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