This year will be testy for bond funds as investors expect shrinking returns in anticipation of the continued Fed rate hikes.

On the whole, however, in 2004 taxable bond funds returned 5% on the average against the background of steady Treasury yields and bond prices. Junk-bond funds and emerging-market funds posted even bigger returns. Closed-end bond funds showed good performance too but began to cut dividends as the cost of borrowing rose.

Now investors are uncertain about what to expect in 2005. "It’s a year of unfinished business," says Art Steinmetz, manager of Oppenheimer Strategic Income Fund.

Some predict a massive bond market crash, especially if the Fed becomes more aggressive with its rate hikes. Closed-funds that rely on borrowing to get money for investment may get hurt especially hard.

"We’re concerned about the twin deficits" in the U.S. budget and trade account, says Christopher Molumphy, chief fixed-income officer at Franklin Templeton. If Asian governments decide to cut the volume of Treasury purchases, the dollar can be seriously impacted, which could trigger inflation in the US.

Others say that if Fed continues with its “measured” pace of accommodation, the market will likely see a flattening of the curve as the difference in returns between long-term and short-term funds will begin to diminish. Short-term bonds will likely get more affected by the changes in the short-term Fed funds rate manipulated by the Fed.