(FORTUNE Magazine) – If you're feeling roughed up by bonds lately, it's no surprise. Not only have interest rates been inching higher, but the Friday after Independence Day saw bond prices take their fourth-biggest percentage drop ever as a strong employment report fanned inflation fears. Amid such turbulence, one safe harbor is Sit Investment Associates in Minneapolis: Morningstar says that Sit's Tax-Free Income fund is almost always in the top quintile in its group, and ranked the U.S. Government Securities fund No. 4 in overall risk and returns for government bond funds in the past five years. The funds finished the 12 months ending in May ranked third and first, respectively. FORTUNE's Bethany McLean got some hints from Michael Brilley, Sit's chief fixed-income investment officer, who seeks bond bargains in strange sites.

Especially in light of the beating bonds took recently, does it make sense to buy now?

It's a reasonably good time. Most likely, the Fed will move rates up by 25 basis points in August, but I think that increase is already reflected in market prices, so a Fed hike may help stabilize things. Currently, rates are quite high relative to inflation [7.18% to 2.9%]. Although the recent statistics show that the economy retains a lot of strength, we don't expect a surge in inflation ahead--3.5% will be the top.

Okay, so what should we be buying?

You achieve the best risk/reward ratio in the ten- to 15-year maturity range. If you look at historical return data, you see that the yield curve flattens beyond 15 years: Rates go up, but only a little. Most individuals tend to buy too short or too long, like five years or 30 years. You really don't get rewarded for the risk of going way out there, and you give up quite a lot of return by staying too short. In addition, most munis have call provisions after ten years, so even if you bet right on rates, they'll call the bond away.

For taxable money, are munis the best bet? Yes, their yield is 87% of that offered by long-term Treasuries, and since any action on tax reform won't come until after the elections, they should maintain their current valuation.

What's your strategy for keeping your portfolio steady even as interest rates fluctuate?

Most people only know that the longer the maturity, the more a bond's value fluctuates. Our goal is to find a bond with a high coupon--when much of a bond's return is from income, its price will be less sensitive to changes in interest rates, so you don't have to worry about that as much. What further lessens a bond's sensitivity to rates is if it can be called at any time: No one will make too big a bet on the future when the time horizon could be quite short. So when you buy a bond with no call protection, you can get paid a high yield to take a risk that may not be that big, and get stability in the bargain.

Okay, I'm intrigued. Tell me more.

Our strategy isn't all that scientific: Take a bond that's been around through various interest rate environments, with a coupon that's just a bit above market--its stated yield is higher than the rate offered on new bonds. If it's been callable for ten years, and it hasn't been called--for a variety of reasons--it probably won't be. Conversely, if it's only been callable for only six months, that's not so good a bet. We look for candidates in the secondary market (where securities trade after they've been issued), where we buy about 75% of our holdings. When you have a newly issued bond, every salesman has got a pitch to sell it. An older bond in a less common market corner means you have to dig deeper. That creates pricing inefficiencies. You do more work, but you find good alternatives to the standard fare.

What are some examples in the muni area?

One is Farmington New Mexico Pollution Control, an old bond--it was sold back in 1978--and it's been callable since 1988. Even though interest rates have been a lot lower a lot of times, it's never been called. It's a high-quality insured bond with a coupon of 6.1%. If you bought an insured, call-protected muni, you're only going to get a yield of maybe 5.5%--and its value is going to fluctuate. Here's a bond that, because it has a high coupon and is callable, is going to be very stable. Your broker may not stock them, but he can find them.

Another issue we like is Foothill/Eastern Toll Road, sold in June of 1995 to build a toll road in Los Angeles. These are uninsured, lower-rated bonds, but we think the senior liens, which have first call on the cash flows, are secure--you know the traffic in L.A. This bond is a zero coupon until 2005, when it converts to a very high yield of 7.1%. This was a $1.3 billion issue, so they're around.

Over half of your government fund is in mobile home mortgages. What's so enticing?

High-interest income, just like regular mortgages. But they don't act like mortgages, where investors can get burned when rates go down and people prepay them. Instead they act like car loans: They're small, maybe $20,000, and they're made by the dealers. How many people do you know who refinance a car? Likely sources for these are Ginnie Mae and Green Tree Financial.