How to play bonds in 2008

Bonds seem likely to struggle, at least through the first half of 2008. Our prescription: Stick to the safest of the safe.

(Fortune) -- For all the subprime-related turmoil in the stock markets, it's the fixed-income markets that have been most shaken by the mortgage tumult and subsequent drying up of credit. (After all, all those exotic CDOs and the like were just gussied-up bonds.)

There's no reason to think the situation is going to improve anytime soon. Changing yields- falling for Treasurys, soaring for junk bonds- "show we've priced in a hard landing, meaning a recession," says David Ader, a bond strategist at RBS Greenwich Capital. "The first half of next year is not going to look good, and the full economic repercussions of what began in housing and moved to bonds will be felt."

Our view: Be very cautious in 2008.

The market is going through what will be a healthy realignment, restoring traditional risk premiums (no more junk bonds offering Treasury-like returns). The bad news is that the value of lower-quality bonds will drop.
So investors who need bonds for income and capital preservation should limit themselves to low-expense funds with the highest-quality options- namely Treasurys and AAA-rated corporates- with short- to medium-term maturities.
Here are three strong funds, each of which has a miserly 0.2% expense ratio. There is the Fidelity Spartan Short-term Treasury Bond Index fund (FSBIX), which has a total return of 8.1% this year, according to Lipper. Eighty percent of its portfolio consists of Treasurys with maturities of one-to-five years.
With inflation a less distant threat than it once was, TIPS (a.k.a. Treasury Inflation-Protected Securities) are also a good choice now, says Jonathan Lewis, a principal at Samson Capital Advisors. We recommend the Vanguard Inflation-Protected Securities fund (VIPSX), which has averaged 6.6% returns over the past five years. Finally, an index fund such as the Vanguard Total Bond fund (VBMFX) (offers a broad mix of Treasurys, corporates, and others, with 80% of its portfolio AAA-rated. Despite having one-third of its holdings in mortgage-related debt, the fund returned 6.9% in 2007.