With uncertainty about the economy and the government deficit, inflation expectations and the direction of interest rates, bond investors are in a pickle.

Short-term bonds, as well as money market funds and short-term bank certificates of deposit, are paying next to nothing. Longer-term bonds don't pay that much either and you risk loss of principal if interest rates rise, as many pundits predict. (Bond prices move in the opposite direction of interest rates. You may lose principal if you have to sell a bond before maturity. This "interest rate risk" is greater with bond mutual funds because as a rule funds never mature and the share price can dip and stay down if interest rates rise.)

Bond prospects seem so unattractive now that in May the managers of the highly regarded Oakmark Equity and Income mutual fund closed the fund to new investors who buy through third-party intermediaries, such as brokers and so-called fund supermarkets.

"Currently, we believe many fixed-income opportunities offer very low risk-adjusted returns and little margin of safety," said Edward Studzinski, manager of the fund, which splits the portfolio about 60/40 between stocks and bonds. "As a result, we feel it is prudent to partially close the fund to show the rate of inflows."

So what to do? Should investors abandon bonds and bond funds or keep their money only in the shortest-term instruments to minimize risk of principal loss if interest rates rise?

For long-term investors, I believe strongly the answer is no. A research paper by Vanguard supports this view, suggesting that a broadly diversified bond portfolio is the most appropriate.

Cynics may contend that Vanguard, a leading provider of bond mutual funds and exchange-traded funds, may not be objective. But I find the analysis rigorous and the conclusions based on common sense.

The paper, "Deficit, the Fed, and Rising Interest Rates: Implications and Considerations for Bond Investors," gets highly technical so I won't go into much detail. The point is that predictions about the economy and interest rates have been "notoriously poor" in the past. Therefore, betting on a narrow sector of the bond market based on predictions can be risky, and the best approach over the long haul remains a diversified bond portfolio.

"Investors have come to understand the conventional wisdom of diversifying stock holdings based on such characteristics as market capitalization and investment style," said Joseph Davis, head of Vanguard's Investment Strategy Group and co-author of the paper. "The benefits of diversification in bonds are equally compelling," including such factors as maturity and credit quality.

Vanguard's paper analyzes hypothetical future annualized returns for U.S. Treasury and corporate bond benchmarks over one, five and 10 years, based on five plausible scenarios, including mounting fiscal deficit and inflation concerns, as well as a prolonged period of low economic growth and low interest rates.

Interestingly, scenarios that produce the highest bond returns in the short term (such as a double-dip recession that pushes interest rates even lower and boosts bond prices) would be expected to produce the lowest returns over the long run. Conversely, scenarios in which rates rise more than expected (such as from a fiscal crisis or a run-up in inflation) could actually produce the highest returns over 10 years, at least before inflation.

That's because rising rates, while depressing bond prices, also produce higher income streams over time. Over the long term, interest income -- and the reinvestment of that income -- accounts for the largest portion of total returns for many bond funds.

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Investing - Keep Bond Portfolio Broadly Diversified | Successful Investing

(c) 2010 Humberto Cruz