Interest rates pose the single biggest risk to the bond market, and one fund manager said that if the Federal Reserve begins to unwind its position in the market, long bonds will be hardest hit.
"There's an asymmetric risk to the long part of the yield curve," said David Albrycht, Senior Portfolio Manager at Virtus Investment Partners. As a result, he suggests that investors focus on short-term bonds, diversifying across sectors and regions.
Albrycht said that if there is a "perfect storm" over the next 12 months of no "headline risk" from Europe, growing GDP, a housing recovery and no exit strategy for the Fed, the yield on the 10-year Treasury could jump to 4 percent from the current 2 percent.
"For the average investor who owns Treasurys, that's a dramatic loss and opportunity cost," he said.
"The Fed doesn't want massive asset price devaluation," he said, so they're very cognizant of putting assets at risk."
Recently, Albrycht said that his fund has been overweight in financials, investment-grade corporate bonds and other high yield debt as well as bank loans. At the end of 2012, Albrycht's Virtus Bond Fund had 17 percent in corporate bonds and 14 percent in bank-loan assets.
"We're starting to do an active rotation out of high yield and into the bank-loan segment," he said.
In an inflationary, high growth environment, Albrycht suggests that investors stay out of assets like Treasurys, long-term municipal bonds and low coupon corporate bonds. Instead, he sees opportunity in high yield bank loan assets, foreign market assets with low exposure to U.S. interest rates and assets in local currencies.
Albrycht said that one of the reasons his fund has been so successful over the past several years is because of its size. Being a smaller fund, he said, allows him to be more nimble and play in areas that larger funds cannot. "We can play in a lot of areas where they can't participate," he said.