Spice up your fixed income

However, if you’re adventurous you may consider adding a touch of spice to your portfolio: you might allocate 10% or 20% of your fixed income to more specialized investments.

READ: A Goldilocks strategy: Building a balanced portfolio for retirement

The key is being selective. Look for investments with clear benefits not provided by core investments. You’ll want good prospects for reasonable returns without taking on too much credit risk or interest-rate sensitivity. Ideally they should perform differently from the broad stock and bond markets, so they can help even out the ups and downs in your overall portfolio. Here are three funds worth considering:

PIMCO Monthly Income Fund: This fund was runner-up for Morningstar’s Fixed Income Fund Manager of the year for 2013. It invests in investment-grade bonds, high-yield bonds and derivatives, but it is best known for extensive investments in U.S. asset- and mortgage-backed securities. “There are some real inherent risks in this strategy, but we’re confident in the people and the processes to manage those risks,” says Christopher Davis, director of fund analysis at Morningstar Canada.  The U.S. parent fund has not had a losing year since inception in 2007. Davis calls the fund a great diversifier since “it can zig when Canadian bond funds zag.” That’s what happened in 2013: it earned 6.35% when many conventional bond funds had modestly negative returns.

Templeton Global Bond Fund: This global bond fund was Morningstar Fixed Income Fund Manager of the Year for 2013. It shows a knack for picking sovereign bonds offering decent yields from developing countries with strengthening economies. You’ll get a lot of currency risk with this fund, but so far it has shown a knack for picking bonds in currencies that appreciate. The top geographical areas for holdings at March 31 were South Korea, Ireland, Mexico and Poland. It also currently holds a particularly large position in cash and short-term bonds, which undermines returns when interest rates are stable, but provides good protection when interest rates rise. Morningstar rates the interest-rate sensitivity as “limited” and the credit quality as “medium.” Morningstar would have rated this fund higher if fees weren’t so high: the MER is 2.19%. “It’s a great manager wrapped in a too-expensive package,” says Davis.

Picton Mahoney Income Opportunities Fund: This is a relatively conservative hedge fund that uses short positions to partially offset the interest-rate risk of its long positions. It uses leverage and invests in high-yield bonds it considers attractive, but also shorts those it considers risky and unattractive. That gives it substantially more credit risk than investment-grade bond funds, but the high-yield short positions moderate some of that risk. “Our hope is that we have less than half the downside of high yield in a sell-off,” says portfolio manager Philip Mesman.

To a large extent, you’re relying on their skill to assess credit risk and pick bonds.

This fund has tended to do well when conventional bond funds perform poorly, but the reverse can be true also. It earned an attractive 8.10% return in 2013, a challenging year for most bond funds, but had a small loss of –2.6% in 2011, when conventional bond funds did well. Like most hedge funds, it has relatively high fees (about 2.3% plus a 20% performance fee on returns exceeding 5%). You can buy it through investment advisers, but complicated restrictions apply in some provinces.