First Take: What’s ahead in the “Yellen Years”

The Senate's genteel handling of Janet Yellen, nominee for chairman of the Federal Reserve, means that the Fed's easy money policies will continue for some time to come. For investors in bond funds, that's bad news followed by worse news. In the Yellen Years, interest rates will remain low for some time, and then they will rise.

The Federal Reserve has two mandates: To keep inflation low and to keep unemployment low. In the wake of the 2008 financial meltdown, the Fed pushed its key short-term federal funds rate to nearly zero. In November 2008, the Fed also began buying longer-term Treasury securities and mortgage-backed securities to push down longer-term interest rates.

Yellen hearing: Senators grill nominee on Fed policies, tapering

Not surprisingly, bond funds rallied strongly. Bond prices rise when interest rates fall. In the three years between September 2007 and August 2010, intermediate-term bond funds soared 67.7%, according to Morningstar. During the same period, large-company blend funds fell 23.9%.

Again, not surprisingly, investors flocked to bond funds during that period, and dropped stock funds like an irritated cobra. But if you listen to Yellen's testimony, she's sounding a warning to bond investors: You've pretty much had your fun.

Although Yellen wouldn't say when the Fed's bond-buying program would end, she did say that she expected interest rates to rise eventually. Rising rates mean lower bond prices. And at current interest rates — the 10-year Treasury note yields just 2.70% — interest payments won't be enough to ease the pain. Already, the average intermediate-term bond fund has fallen about 2.09% — including interest — so far this year.

Bond bear markets tend to be less painful than stock downturns, but they can last an awfully long time. Interest rates rose from the end of the Great Depression to 1981, when the 10-year T-note hit 15.84%. Treasury securities were called "certificates of confiscation."

Currently, the Fed is targe! ting a 2% inflation rate, measured by its favorite inflation gauge, the personal consumption expenditureprice deflator. The PCE is still comfortably below that level, having gained just 0.9% the past 12 months.

But, as John Lonski, Chief Capital Markets Economist, Moody's Analytics, notes, it's likely that the Fed will overshoot its target, meaning that it's also likely that long-term bond yields will rise higher than the Fed would like, at least temporarily. If you're a bond investor, you should consider looking at funds that invest in shorter-term bonds. They will offer lower yields, but somewhat greater protection against rising interest rates.

You should also consider bonds issued by companies — or even states — whose credit ratings will improve when the economy does. You don't have to go all the way to junk-bond levels. But a short-term corporate fund that dabbles in bonds with less-than-stellar credit ratings might be the best way for bond investors to navigate the Yellen Years.