Bond funds when interest rates rise

If the Federal Reserve raises interest rates later this year, which would be more likely to lose principal -- short-term bond funds or intermediate-term bond funds?

My understanding is that a rise in interest rates affects long tem bonds the most, intermediate term bonds less, and short term bonds the least. To minimize interest rate sensitivity, stay with short term bonds.

If you own a bond and plan to hold it to maturity then you will receive your principal regardless of what interest rates do.

Actually, the correlation between the Federal Reserve and bonds is an indirect one at best. That is, the Fed has no direct influence over bond coupon rates. Bonds sold by the Treasury are sold at auction. Corporate bond rates are set by underwriters -- the amount depends on the creditworthiness of the company and the state of the economy, which is where inflation comes in.

Inflation reduces the return of fixed-income investments like bonds. Consider that you buy a bond for $1,000 that will return 4%, or $1,040, in 30 years. If inflation stays below 2%, which is where it has hovered over the past few years, then you're in good shape, you make a $20 profit. However, if inflation climbs to 5% or more, you'll lose money. In bond circles this is what is known as "inflation risk," and it gets priced into the coupon rate. The longer the term, the greater the inflation risk.

One of the Fed's many jobs -- but perhaps the most discussed -- is to keep inflation under control by expanding or tightening the money supply. An interest rate move, or how the Fed explains its actions, offers clues to future inflation rates. So the bond market doesn't necessarily respond to the Fed, but rather to the Fed's expectations about inflation.

For more on bonds, see Add Balance With Bonds (http://www.kiplinger.com/basics/archives/2003/04/bonds.html).

Treasurydirect.gov is a great resource for several US Gov't obligations including Treasury Inflation Protected Securities (TIPS), and you can buy direct online. When considering any debt obligation, including bonds or bond funds, consider US Gov't obligations for the best credit rating available, and zero call risk.

Bond funds have no fixed maturity or set interest payment schedule because the underlying bonds are bought and sold constantly on the secondary market. This makes bond funds especially sensitive to the impact of interest-rate changes on bond prices.

As with individual bonds, interest-rate risk increases as the average maturity of a bond fund increases. So a long-term bond fund with maturities of 10 years or more will lose more value when interest rates climb than a short-term fund holding bonds that mature in 1 to 3 years. And when interest rates are falling, investors in long-term bond funds can expect the funds to appreciate in value more than shorter-term funds.