For decades, you could put some of your money into mainstream bond funds for a fairly safe cushion against the volatility of the stock market. Not anymore.

Interest rates are so low and the likelihood that they will rise over the next several years is so high that typical bond funds could end up suffering significant losses, as some funds did early this year when rates rose. (Bond prices move inversely to interest rates.)

But in recent years, various money-management firms have come up with a new kind of fund—the “unconstrained” bond fund. These funds, free of the typical restrictions and guidelines and able to use elaborate defensive strategies, can make big bets and dramatic and sudden shifts in their portfolios to avoid risks as they search the globe for opportunities. What you need to know…

HOW THEY WORK

Unconstrained bond funds give managers great freedom to choose fixed-income investments, regardless of the length of maturity, credit quality, type of issuer or country. They’re even able to bet that bond prices will drop, and they buy exotic instruments such as credit default swaps, which act like insurance in case of bond defaults.

HOW TO USE THEM

I wouldn’t completely replace an investor’s core bond funds with unconstrained funds just yet. They have to prove themselves in a prolonged period of rising interest rates. Instead, I recommend that investors use these to replace the riskiest portions of their fixed-income portfolios. These include funds holding bonds with average durations greater than 10 years. (Duration is a measure of how much a bond’s price is likely to rise or fall as a result of interest rate changes.) These longer-duration funds are likely to suffer double-digit losses if rates rise significantly.

Three no-load, unconstrained bond funds to consider…

  • Pimco Unconstrained Bond Fund (PUBRX). With $20 billion in assets, this four-year-old fund is one of the oldest and, by far, the largest in the category. It also is one of the most conservative, spreading its bets across more than 1,500 bonds, with a recent average duration of less than half a year. Fund manager Chris Dialynas works with legendary Pimco manager Bill Gross to shape a portfolio with low volatility. Because of the fund’s cautious approach, its returns, which totaled 8.3% in 2012 and 0.56% this year as of February 22, are likely to trail more aggressive offerings over the long term. Expenses: 1.55%. www.Pimco.com
  • Metropolitan West Unconstrained Bond Fund (MWCRX) is more aggressive than the Pimco fund, with better returns since its debut in September 2011 and lower expenses. Manager Tad Rivelle’s forays into high-yield and emerging-market debt and mortgage-backed securities boosted returns in 2012, which totaled 15.8%, and 1.14% through February 22 this year. Average duration: 1.2 years. Expenses: 0.99%. www.MWAMLLC.com
  • Scout Unconstrained Bond Fund (SUBYX) is one of the boldest, with a portfolio of nearly 40 bond holdings and a recent average duration of 2.1 years. Since the fund’s September 2011 launch, manager Mark Egan has produced some of the best returns in the category, thanks to a successful gamble on asset-backed securities, which are pools of credit card debt, leases and other loans packaged like bonds. The fund had returns of 22.8% last year and 2.3% through February 22 this year. Expenses: 0.8%. www.ScoutFunds.com