To avoid the recent volatility in the bond market, consider these three rules and three funds. By Steven Goldberg, Contributing Columnist April 15, 2008 Stretching for a little extra yield has turned into a dangerous game in this market. Exhibit A is Schwab YieldPlus, an ultra-short-term bond fund that promised investors a bit more yield for investing in a product that bought IOUs with just slightly longer maturities than found in money-market funds. "Discover a smart ultrashort taxable bond fund," Schwab's Web site still boasted last week. "The fund's objective is to seek high current income with minimal changes in share price." Scratch that plan. The fund (symbol SWYPX), has plunged 26% in the past 12 months through April 14, including a sickening 15% loss in just the past month. What happened? The fund kept its duration (a measure of interest-rate sensitivity) safely short -- just one year. That meant that if interest rates rose one percentage point, the fund should have been expected to lose only 1% in price. But Schwab YieldPlus held a whopping 40% of its assets in collateralized mortgage obligations not backed by guarantors Fannie Mae or Freddie Mac. Advertisement Since last June, when the fund held $13.5 billion, investors have fled. As of April 1, the remaining assets totaled just a bit more than $1.5 billion. As investors stampeded for the exits, Schwab was forced to liquidate its bonds at fire-sale prices. Sadly, Schwab YieldPlus is not alone, nor is it even the biggest loser. That dubious honor belongs to Regions Morgan Keegan Select Intermediate Bond A (MKIBX), which plummeted 50% last year and has already lost 44% this year. The fund held more than $1 billion in early 2007, before its mix of mortgage-backed and asset-backed securities headed south. SSGA Yield Plus (SSYPX), an ultra-short-term fund much like the Schwab fund, has lost 30% of its value in the past year. Again, mortgage- and asset-backed securities were the problems. What's an investor to do? Bonds are an integral element of almost every portfolio. Funds are easier to buy than individual debt securities and offer the advantages of diversification and, theoretically, professional management. Advertisement Here are three good rules: If it looks to good to be true, it probably is. In fact, we've been through this nightmare before. In 1994, Piper Jaffray Institutional Government Income, previously a star performer, lost 29% after complex mortgage derivatives blew up during a rotten year for bonds. If a bond fund is doing a whole lot better than its peers, make sure you know why before you invest. Keep expenses low. Bonds are a game of inches. It's hard to win by a lot -- without taking supersize risks (see above). That makes annual expense ratios crucial. Vanguard charges as little as 0.15% a year on many of its bond funds. Fidelity charges about the same for its bond index funds and about 0.45% a year for many of its actively managed bond funds. Unless you've identified a superior manager -- who has prospered in a variety of market cycles -- why buy a more expensive fund? Don't take risks -- unless you're being well compensated. Bonds are your safe money. You take your big risks -- and make your big profits -- with stocks. Bond funds and money-market funds are designed to provide ballast to your portfolio and pay a modest amount of income. Given the current economic weakness, the market isn't paying enough in extra yield to lure me into high-yielding "junk bonds." And with the risks of higher inflation, I'd shun long-term bonds. Advertisement That said, here are my three favorite funds: Vanguard Intermediate-Term Tax Exempt (VWITX) boasts expenses of just 0.15% and invests in high-quality bonds. Their average credit rating is AAA. The fund's bonds mature in 6.7 years, on average. It yields 3.6%. Harbor Bond (HABDX) is an intermediate-term taxable bond fund run by the bond market's reigning superstar, Bill Gross. For more than two decades, Gross's nearly identical Pimco Total Return fund has delivered market-beating returns. Over the past ten years, Harbor Bond, which he subadvises, has beaten the Lehman Brothers Aggregate Bond index by an average of 0.7 percentage point per year. That's about as good as it gets in a low-risk vehicle. Expenses for this Kiplinger 25 fund are just 0.56% and the fund yields 4.5% Advertisement Loomis Sayles Bond (LSBRX) is an exception to the rules. For starters, it charges an above-average 0.97% annually. It buys a fair amount of "junk bonds," although its average credit quality is single-A. And it often buys long-term bonds. What I like about this fund is Dan Fuss. He has been investing in bonds for a living since the 1960s. He's seen it all, and he seems as sharp as ever. Co-manager Kathleen Gaffney has now been with the fund ten years. Both know how to identify bargain bonds that others are overlooking. The returns: Over the past ten years, the fund, a member of the Kiplinger 25, has beaten the Lehman Brothers Aggregate by an average of 2.25 percentage points per year. It yields 6.5%. Steven T. Goldberg (bio) is an investment adviser and freelance writer.