(MONEY Magazine) -- While you needed a Costco-size supply of Dramamine to survive the stock market's choppy ride to nowhere both last year and over the past decade, you required no such relief when it came to your bonds -- or at least one type of bond.
In recent years all you had to do was scoop up Treasuries to satisfy pretty much all of your fixed-income needs. And the easiest way to do that was through a single fund, a total bond market fund that invests mostly in Treasuries and other U.S. government-related debt. The Vanguard Total Bond Market index (VBFMX) fund, for instance, returned nearly 7% in 2011 and nearly 6% annually over the past decade, when U.S. stocks made you very little.
Now the bond market is approaching uncharted waters -- or, more accurately, waters you've probably not seen in your investing career or even your lifetime. The very force that made the bonds so bountiful in recent years -- sharply falling interest rates that boosted prices and drove up total returns -- have pushed yields on 10-year Treasury notes down to 2%.
That is an important development for three reasons:
Real yields are now negative. In 2009, when Treasuries were paying you close to 3.5% (which seemed paltry back then), inflation was nonexistent. That meant that the 3.5% payout was completely intact. Today, Treasuries and even total bond market index funds -- which are yielding a slightly more palatable but still modest 3% -- are paying less than the rate of inflation.
"Treasury bond buyers are locking in a likely negative real rate of return for the next 10 years as inflation could erode one's purchasing power at a clip far greater than the meager interest paid by bonds at this time," says Darren Pollock of Cheviot Value Management.
Your total returns are under threat. There's another problem. With Treasury yields at 2%, there's not much room for interest rates to fall further, so there's little hope for a big jump in bond prices. That means "your total return is now going to be a function of the interest you get," says Jim Kochan, chief fixed-income strategist at Wells Fargo Advantage Funds.
Treasuries are yielding less than stocks. It may seem strange that you're getting less income from your Treasuries than the Standard & Poor's 500 index. For the first half of the 20th century, though, that was actually the norm. It wasn't until the late 1950s, in fact, that investors began to earn the lion's share of their income from their fixed-income portfolios. And if history is a guide, that means you might be in store for some disappointing bond returns in the coming years.
This isn't an argument for bailing on bonds. To squeeze out more income, though, you'll have to get more creative, says Jeff Layman, chief investment officer at BKD Wealth Advisors.
In the past his firm relied solely on Treasuries, U.S. government agency debt, and high-grade corporates or, depending on the circumstances, tax-exempt municipal debt. "We can't keep pace with inflation sticking to that strategy," he says. So now the planning firm carves out about 25% of its fixed income portfolio for alternative income investments like high-yield bonds and foreign debt.
That's a good guidepost for thinking about your own portfolio, but it's just a starting point. Your strategy will vary by your aversion to risk and your age. The point is to do something now to lift your income and upgrade your bond portfolio to reflect this new era. The two-step approach that follows will have you casting right on target.
STEP 1: STRENGTHEN YOUR CORE
Go beyond a simple index of high-quality bonds
For years the smartest thing you could do with your bond portfolio was to put it all in a broad market index fund. Now, says Kathy Jones, fixed-income strategist at the Schwab Center for Financial Research, relying on that same index fund, and its 3% yield, no longer cuts it.
That's because it traffics in two low-yielding areas of the fixed-income world -- around 75% of the Barclays U.S. aggregate bond index tracks Treasuries and government agency debt, with the rest held largely in high-quality corporates.
What to do: Supplement your core bond holdings with tax-exempt municipal bonds. A good rule of thumb is that when yields on tax-free bonds are at least 85% of the yield you can earn on comparable Treasuries, municipal securities are attractive.
Craig Elder, senior fixed-income analyst at R.W. Baird, says that by this measure munis are much more compelling. A one-year high-quality muni, for example, is yielding 121% of a one-year Treasury bill. Meanwhile, 10-year munis are paying out about 110% more than Treasuries of comparable maturity. So even before factoring in the tax advantage of these bonds, you're ahead of the game.
To be sure, the general fiscal health of cities and states has been called into question, with the recent bankruptcy filing in Jefferson County, Ala., and the fiscal problems in Harrisburg, Pa. Overall, however, less than 1% of munis defaulted last year as of November, according to Standard & Poor's.
Funds to choose: You can manage your risk while also grabbing more yield by putting a small amount into a municipal bond fund that trawls only in investment-grade credits -- those rated BBB or higher. That should provide you with some insulation should the economy take a turn for the worse.
The typical holding in the Vanguard Intermediate-Term Tax-Exempt (VWITX) fund, a MONEY 70 pick, has an average credit quality of A, according to Morningstar. Plus, the muni bond fund sports a current yield of 3.6%; if you're in the 28% federal income tax bracket, that is the equivalent of earning 5% on a taxable bond.
Keep your interest-rate risk in check
With rates so low and with signs that the U.S. economy is picking up a little steam, it's only natural to worry that interest rates will start to inch up. They already have since September, when 10-year Treasuries yielded a mere 1.7%.
In a rising-rate environment, you need to keep an eye on something called duration, which is a measure of how sensitive your portfolio is to interest-rate fluctuations (you can look up bond fund durations at morningstar.com). A fund with an average duration of three years is likely to lose 3% if rates were to climb by one percentage point. Market strategists think you'd be safe keeping your overall duration to five years.
How to do it: Don't just assume that a core holding in an intermediate- term bond fund will do the trick. Nearly a quarter of the funds in this group have average durations of more than five years.
Also, when you add municipal bonds to your core, make sure you maintain your target duration. The average for a municipal bond fund, for example, is 6.6 years, but Vanguard Intermediate-Term Tax-Exempt's average is only a little more than five years.
STEP 2: SEEK MORE YIELD OUTSIDE YOUR CORE
Venture into foreign bonds.
Not only do high-quality U.S. bonds pay diddly, but Uncle Sam's balance sheet doesn't exactly merit a gold star. Sure, parts of Europe are worse. But plenty of emerging-market nations -- and even some developed economies -- have less debt and better prospects for growth in the coming years. And some are spitting out more bond income.
"U.S. real yields are at zero, but Brazil's real yield is 6%, and Mexico's is 3%," notes T. Rowe Price bond fund manager Steve Huber.
How to do it: Bohemia, N.Y., financial planner Ronald Rogé says investors who are really wary of risk -- such as retirees who have already begun tapping their accounts -- can start small by moving about 10% of their fixed-income holdings overseas.
There's a catch, though. A recent study by Vanguard found that foreign-currency movements can add a good deal of volatility to your bonds. As a result, stick mostly with funds that hedge their currency bets -- in other words, when they use yen to buy Japanese bonds, they sell an equal amount of the currency. John Lovito, a portfolio manager at American Century Investments, recommends investors hedge 70% to 80% of their foreign bond stake, with the remaining 20% to 30% or so left unhedged.
Funds to choose: For the hedged portion of your portfolio, go with a broad-based fund such as Pimco Foreign Bond (PFOAX) (USD-Hedged). If you prefer an index option, Vanguard is set to launch in January a hedged total international bond index fund that will track the Barclays Global Aggregate ex-U.S. Bond index. For your unhedged position, try T. Rowe Price International Bond (RPIBX), a MONEY 70 fund that invests in high-quality foreign government and corporate debt.
Add some junk
Okay, dabbling in bonds issued by companies with less-than-pristine balance sheets might seem the antithesis of safe and secure investing.
You can mitigate that risk, however, by holding them through diversified funds and by keeping your weighting in the funds small.
The fact is, junk bonds offer the best value in today's hard-to-navigate fixed-income seas. "You're taking credit risk, but this is the best time to do it," says Kathleen Gaffney, a portfolio manager with Loomis Sayles & Co., noting increasing signs that the U.S. economy is likely to sidestep another recession.
She says the fact that junk bonds yield seven percentage points more than Treasuries is paying you for taking that risk -- and that the higher yield gives you a bigger cushion when rates eventually do rise.
What's more, once rates start to lift, that will be a sign the economy is picking up, and that's good for the financial health of junk issuers.
How to do it: Classic high-yield bonds get the nod over floating-rate bank loan funds, which are increasingly popular lately. Floating-rate funds comprise lower-quality debt, and as the name implies, they do better when rates pick up. (Think the corporate equivalent of HELOCs.)
With Federal Reserve chairman Ben Bernanke stating that he'll keep short-term rates steady for at least the next 18 months, there's not a screaming reason to invest in bank loan funds, however. Today they yield about three points less than regular junk bond funds and tend to be more concentrated in economically sensitive areas of the market.
Funds to choose: To play it safe, go with a fund that focuses on debt issued by firms with better-than-average balance sheets within the junk universe, such as Fidelity High Income (SPHIX). Nearly 80% of its holdings are rated B or BB, far more conservative than its peers.
Get more income from stocks
As bond rates have sunk, dividend- paying stocks have begun to present interesting opportunities. Plenty of blue-chip shares yield 3% to 5%, exceeding the yields on many high-grade corporate bonds.
Take Microsoft (MSFT, Fortune 500). The tech giant's stock throws off a 3% dividend yield, while most of its bonds pay lower fixed-interest rates. Yet Darren Pollack of Cheviot Value Management says Microsoft "has ample room to raise its dividend prospectively, trades for approximately nine times profits, and is growing its earnings at a very acceptable rate." So would you rather own the stock or the bond?
How to do it: Despite the appeal of dividend payers, this is not an endorsement to sell your core bond portfolio and pile everything into equities. Stocks, no matter how attractive, are far riskier than bonds. Within your equity portfolio, however, you can tilt your focus.
If you have most of your blue-chip holdings in an S&P 500 fund, you're collecting a dividend yield of around 2.1%. Move 20% or so of that slice into funds that emphasize payouts.
Focus on firms with a history of increasing dividends. Greg Thomas, whose investment firm, Thomas Partners, specializes in dividend stocks, found that companies that increased or initiated payments between 1971 and the end of 2010 had an annualized return of 14%. Dividend payers that didn't increase payouts gained 9.9%, and firms that didn't pay dividends returned 3%.
Funds to choose: MONEY 70 member SPDR S&P Dividend ETF (SDY) focuses on dividend payers that have managed to boost payouts every year for at least a quarter-century. SDY currently yields 3.2%.
Another good option is Vanguard Dividend Growth (VDIGX), which seeks high-quality companies that have the capacity to boost their dividends three percentage points more than the annual rate of inflation. That type of inflation protection is something fixed-interest bonds will be hard-pressed to pull off, given today's low yields.
More stories from the 2012 Investor's Guide:
Best bets in tech for 2012
Industrial stocks: Ready for a rally
Carlos Rodriguez is trying to rid himself of $15,000 in credit card debt, while paying his mortgage and saving for his son's college education.
Susan Carson and Laura DeLallo make $225,000 and have half a million in retirement savings, but their sprawling portfolios is proving hard to manage.
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