Scenario 2: You crave high returns

Paul J. Lim, assistant managing editor


What you've been doing: Buying longer-term and emerging-market bonds.

The allure of supercharged economies like China and Latin America -- coupled with relatively healthy government finances in those regions -- drove four times as much money into emerging-market bond funds last year than in 2005, which had previously been the best year for this group.

These funds, which have soared an average of 12% a year over the past decade, used to be a great deal.

In the fall of 2008, emerging-market bonds were paying nearly 15% vs. 2.9% for 10-year Treasuries. But today they're yielding only 5.4%. And the spread between emerging-market debt and Treasuries is narrower than it was before the panic in early 2007.

What's more, several emerging-market economies, including China and India, have been growing so fast that their central banks have started hiking rates to choke off inflation. More increases could cause more volatility and losses. That's already happening.

Since Nov. 4, when investors began to worry that China would have to hike rates because of higher food prices in that country, emerging-market bond funds have lost 3%.

As for long-term bonds: Yes, their returns have beaten those of shorter-term issues. But take a look at 30-year Treasuries. Since 1980, their yields have plummeted from 15.2% to 4.4%. "How much further could yields really drop?" asks James Swanson, chief investment strategist for MFS Investment Management.

Well, let's say yields were to sink back to 4%. A long-term bond fund with a duration of 15 years could gain 6% in value. But if rates were to climb up to 5%, your fund could sink 9%. That's a lot of risk with what's supposed to be your "safe" bond stash.

Smarter strategy: Diversify -- and buy some convertible securities

Invest in emerging markets through a diversified portfolio that focuses on government debt, which is less volatile than the corporate kind. A great choice: Fidelity New Markets Income (FNMIX), which has beaten 91% of its peers over the past five years.

Next, hedge your emerging-markets stake with bonds issued in the developed world, suggests Loomis Sayles's Gaffney. You may not even give up much in return. Pimco Foreign Bond D (PFBDX), for example, which invests mostly in such debt, earned about 1% over the past six months. But because the dollar slumped around 7% in the second half of last year, that translated into an 8% gain.

And even though European government bonds have taken a hit owing to the debt crisis in Greece and Portugal, Treasuries issued by governments in the northern part of the continent (such as Germany, France, and Finland) and other parts of the developed world (Australia, Canada, New Zealand) have held up well. Invest via a broad-based fund such as T. Rowe Price International Bond (RPIBX), which is in the MONEY 70, our list of recommended funds.

Finally, add in some so-called convertible debt. These hybrid securities can, under certain circumstances, be converted into shares of the issuing company. As a result, their prices will rise in tandem with the company's stock price though they won't go as high. And if the stock price falls, the bond's yield will cushion the blow.

A terrific example is Calamos Convertible A Load Waived (CCVIX.LW). In 2008, when the S&P 500 fell 37%, this fund, which holds convertibles from a variety of industries, was down about 26%. But in 2009, when the S&P rose 26%, Calamos Convertible gained even more: 34%.

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