Ben Levisohn

Updated July 24, 2010 12:01 a.m. ET

With Treasury yields falling back down near record lows, it may be time to put away the bond ladder and break out the barbell.

Laddering a portfolio of bonds has long been a staple of do-it-yourself bond investors. It boils down to purchasing an equal amount of bonds over a range of maturities, from shortest-term to longest. The goal: to minimize the risk of rising or falling interest rates.

In normal markets, a bond ladder is easy to set up and can boost yields without adding much risk.

But the bond markets these days are especially fraught. The rate on the two-year Treasury touched a record low of 0.0552% on Thursday. Yet Treasury yields could snap back viciously, as they did in 2009, 2004, and 1994, when stronger economic data stoked inflation fears and prompted big Treasury selloffs.

Amid the unusually uncertain economic outlook, as Federal Reserve Chairman Ben Bernanke told Congress this week, some money managers are turning to another strategy to boost yields: the barbell portfolio.

Rather than equally weighting maturities to create a ladder from low to high, a barbell portfolio has half of its holdings in short-term bonds and the other half in long-term bonds. With so much invested on the short end, the investor has greater flexibility to respond to sudden changes in the bond markets, says James Barnes, a senior fixed-income portfolio manager at National Penn Investors Trust Co. in Wyomissing, Pa.

The easiest way to structure a barbell portfolio is to purchase bonds at auction via TreasuryDirect.gov. The government is scheduled to sell one-year bills on July 26 and seven-year notes on July 29. It hasn’t scheduled a 10-year note auction.

The best time to use the barbell strategy is when the yield curve, or the difference between short-term and long-term yields, is steep. The bet is that, over time, the difference between the two will narrow.

That is precisely what is happening now. Since April, the yield curve has dropped 0.85 percentage point to 3.83.

Barbells can be risky, however. The dramatic steepening of the yield curve in 2008 pounded barbell portfolios, erasing several years of outperformance, according to data provided by Thornburg Investment Management in Santa Fe, N.M.

A ladder works more often and to a greater extent than a barbell, says Chris Ryon, a portfolio manager at the Thornburg Strategic Municipal Income Fund, which has $56.7 million in assets.

Still, the next year or so could continue to favor the barbell. The last time the yield curve was this steep, back in 2004, a barbell portfolio of one-to-three-year and seven-to-10-year Treasurys outperformed a laddered portfolio by 0.7 percentage point the following year, as the difference between one- and 10-year yields narrowed.

This time around, two different scenarios could cause a flattening of the yield curve. The economy could continue to sputter and, in a worst-case scenario, spark deflation, which could push yields on the 10-year Treasury note as low as 2%.

Or the economy could stumble along for the next 12 months before recovering enough for the Fed to raise interest rates quickly because of increasing inflation concerns. In that scenario, the short end of the curve typically rises faster than the long end.

What could hurt the barbell? A steepening of the yield curve back toward the near-record high of 4.67 points reached in April. If yields on 10-year notes, now below 3%, should return to the 4% of just a few months ago, investors would stand to lose about 10% on the long end of the barbell.

Still, many bond strategists are betting that the curve will return to a flatter state over time.

When you look at the steepness of the yield curve, there’s more potential for flattening than for further steepening, says Scott D. Einhorn of Samson Capital Advisors, which manages more than $7 billion.