January 25, 2013|Joe Light, The Wall Street Journal

For the past five years, the Federal Reserve has pushed down the interest rates on traditionally safe assets such as Treasury bonds to near record lows, in hopes of sparking the economy. Today’s 10-year Treasury rate of about 1.95% is about half its level in January 2008.

Rock-bottom rates hurt retirees investing for income—and create a dilemma for the millions of savers who rely on bonds to steady their stock portfolios. Bond prices move in the opposite direction of yields, so when prices fall, yields climb. With prices near record highs, even a small move can produce losses for investors.

Long-term bonds are especially vulnerable. In just the first four days of the year, the price of 30-year Treasurys fell by 3.1%, a drop that would have eaten up their entire yield for 2013, assuming prices held steady.

Other seemingly safe bonds are at risk, too. Bank of America Merrill Lynch recently estimated that investors will suffer losses if 10-year Treasury yields rise above 2.23% in the next year. Investors in the highest-rated 10-year municipal bonds will suffer losses if yields rise more than 0.27 percentage point to 1.94%.

“Why take a higher risk in bonds when the potential reward is so low? It makes no sense,” says Joe Alfonso, a financial planner at Aegis Financial Advisory in Portland, Ore.

But there are ways for investors to manage these rising risks, first by reducing exposure to certain segments of the bond market and then by venturing into other assets that have better prospects for returns. Investors also need to pay even more careful attention to fees, and to tread lightly in mutual funds and exchange-traded funds.

Why Bonds Still Make Sense

It is difficult to muster much enthusiasm for an asset class that has rallied for most of the past 30 years and now stands near record highs. Yet investors would be unwise to flee the bond market completely, experts say.

That is because bonds serve not only as a source of income but also to buffer the volatility of the stock market.

Compare, for example, a portfolio consisting only of the Standard & Poor’s 500-stock index with one holding 60% in the S&P 500 and 40% in a total-bond-market index fund.

Over the past five years, the 60/40 portfolio has done better overall, with an average annual return of 4.7% after fees, versus 4.2% for the all-stock portfolio. But the real story is the difference in volatility. In 2008, the all-stock portfolio lost 37% of its value, while the blended portfolio lost only 20%. Less-volatile portfolios increase the chances that investors will stick with their holdings rather than panic and sell after a steep short-term drop.

The trouble now: With yields near record lows, bond prices seem especially ripe for a fall. While bonds should still be steadier than stocks, their returns won’t be nearly as robust, experts warn.

What to Avoid

Traditionally, the simplest and cheapest way to build a bond portfolio has been to buy a bond mutual fund. But a number of factors make bond funds unattractive now.

First and foremost is interest-rate risk. A bond index fund, such as the Vanguard Total Bond Market Index Fund, which tracks the Barclays Capital U.S. Aggregate Float Adjusted Index, has an average “duration,” a measure of interest rate sensitivity, of about five years. That means that for every one-percentage-point increase in interest rates, the price of the fund will drop 5%.

In theory, mutual funds that don’t seek to replicate the exact risk and return of the overall bond market can minimize their exposure to the risk of rising interest rates. But, in practice, the median actively managed U.S. bond fund carries about the same interest-rate risk as the index, according to Morningstar.

Bond index funds and ETFs have additional flaws.

Because most bond indexes are weighted by market capitalization, the companies and countries with the most debt end up getting the biggest allocations, notes Ben Inker, co-director of asset allocation for institutional money manager GMO, which oversees $104 billion. Yet as a country or company borrows more, its debt tends to become riskier.

Laddering Up

Many wealthy investors eschew bond funds and instead create “ladders” of individual government or corporate bonds.

A ladder is a series of bonds that mature in succession, giving investors both yield and a steady stream of principal repayments—getting all their original money back—as the bonds mature. For example, an investor might buy bonds that mature each year between 2014 and 2019. When the 2014 bond matures, he can use the proceeds to buy a new bond that matures in 2020, and so on.

That offers some protection against rising interest rates, because investors can roll over lower-yielding bonds into higher-yielding ones as their bonds mature, notes Garth Scrivner, a financial planner in Albuquerque, N.M.

But bond ladders require huge investments. While ladders of Treasurys can be created for just a few thousand dollars, it can take $1 million or more to build a diverse enough ladder of corporate bonds at decent prices.

Lately, some ETF providers have tried to solve that problem.

Guggenheim Partners in 2010 launched a series of ETFs that let investors simulate a diversified investment-grade corporate bond ladder at much lower cost. For example, one rung of that ladder, the Guggenheim BulletShares 2017 Corporate Bond ETF, costs 0.24% annually, or $24 for every $10,000 invested, and has a 2.6% yield. It tracks a portfolio of 237 bonds—but in four years it will terminate and disburse its assets to investors in a lump sum, much like an individual bond would.

“It’s probably the most cost-effective way for an individual to build a corporate bond ladder,” says Timothy Strauts, an ETF analyst at investment researcher Morningstar.

IShares offers similar products for municipal bonds called iShares AMT-Free Muni Bond ETFs. The 2016 maturity fund, for example, has an expense ratio of 0.3% and a yield of 1.4%.

Reducing Interest-Rate Risk

The bond boom has left almost all bonds looking expensive. The key for investors is to tie as little money as possible to the fate of interest rates in general, and to take other kinds of risks instead.

The easiest way to reduce interest-rate risk is to lower the overall duration of a bond portfolio, notes Curt Gross of FAI Wealth Management in Columbia, Md. A typical total-market bond fund has a duration of 4½ to five years. Mr. Gross says that over the past year he has cut the duration of a typical client’s portfolio in half, to about 2½ years.

Instead of investing in the Vanguard Total Bond Market Index mutual fund, which has a duration of about five years, investors could switch to the Vanguard Short-Term Bond ETF, which has an average duration of about 2.7 years, according to Morningstar. The ETF charges 0.11% a year and has 1.6% yield.

The iShares 1-3 Year Treasury Bond ETF costs 0.15% and has a duration of 1.75 years and a 0.4% yield, according to Morningstar.

It might even make sense for investors to put a chunk of their bond portfolio in cash or cashlike investments such as certificates of deposit or Treasury bills, says Brian Singer, portfolio manager of the $57 million William Blair Macro Allocation Fund.

“Cash is not the worst investment in the world right now. When there’s inflation or the Federal Reserve stops manipulating rates, Treasury bills will have the ability to reprice,” he says. “With longer-term bonds, you’re locking in a negative return [after inflation] over a long future.”

Money-market mutual funds and accounts insured by the Federal Deposit Insurance Corp. pay little interest. There are other ways for small investors to see their cash keep up with inflation while taking little risk.

I Savings Bonds, which can be bought from the government at TreasuryDirect.gov, pay an interest rate that adjusts every six months to reflect changes in the consumer-price index, the government’s main inflation measure.

The drawbacks: Investors can’t cash in the bonds for at least a year and face a penalty of three month’s interest if they redeem before five years. But the bonds will keep up with inflation even as other low-risk short-term investments lose money.

Be careful with Treasury inflation-protected securities, Aegis’s Mr. Alfonso says. The securities adjust their principal, rather than their interest rate, based on the CPI. The risk is that if interest rates rise, long-term TIPS would lose money along with other bond investments, Mr. Alfonso says.

Risks That Could Pay Off

Once investors control their interest-rate risk, they can look for ways to take other kinds of risk that promise a better payoff.

Along with all bonds, traditionally “high risk” investments, such as high-yield corporate bonds and emerging-market government bonds, have seen their yields plummet as investors have piled in.

But such investments could hold up well even if rates rise moderately, notes Rob Arnott, chairman of Research Affiliates, whose strategies are used to manage $125 billion. That is because rising interest rates can signal improving economic conditions, which lowers the chances of default for such bonds.

Emerging-market government bonds might be one of the last remaining places to find a decent return, Mr. Arnott says.

Countries that issue such bonds right now make up about 40% of the world’s gross domestic product but issue only 10% of its sovereign debt, meaning they should have ample revenues to pay the bonds.

“They have a sensible spread and a sensible long-term rate of return,” he says.

The PowerShares Emerging Markets Sovereign Debt ETF, for example, has a 4.6% yield and a 0.5% expense ratio. The iShares Emerging Markets USD Bond ETF charges 0.59% with a 4.2% yield.

Another option with little interest-rate exposure: bank-loan funds, or pools of loans made to companies. Also known as floating-rate funds, they are subject to little interest-rate risk because the loans have adjustable rates and therefore can rise, FAI’s Mr. Gross notes.

To be sure, many of the companies carry a lot of debt, meaning there is a higher likelihood that such loans will suffer defaults if the economy suffers another downturn.

But the loans offer higher yields to compensate for those risks. One low-fee ETF option is the $1.7 billion PowerShares Senior Loan Portfolio, which carries an expense ratio of 0.76% and yields 4.8%.

Floating-rate funds generally pay less than the 6% interest available in high-yield bond funds, which hold corporate bonds rated below investment grade.

But, says Mr. Gross, “Right now, it’s rising rates I’m worried about.”