Low bond yields got you down? Some feisty alternatives

I'd like to make an argument for altering the traditional 60/40 portfolio. For decades the conventional wisdom has been that one should put 60 percent of one's assets at risk in stocks, while leaving the remaining 40 percent in less risky income-producing bonds.

It's my view that the thinking about the bond side of this equation could use some revising.

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For decades, bonds had two things going for them. First, they had an attractive rate of income, which many call "yield." A yield of mid-single digits was the norm for most of the last 50 years, although my clients do still remind me of times when these yields were temporarily above 10 percent.

Having 40 percent or so of a total portfolio in an investment vehicle providing a 4 percent to 7 percent return would provide a healthy dose of income to offset the volatility in the stock portion.

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The second benefit of bonds over the past few decades has been rising prices, which have boosted the total return for bonds to levels beyond just the yield.

The problem is that at today's interest rates, traditional bonds no longer provide the safety net of healthy income, as yields are near historically low levels. Most investors, including those at Glassman Wealth, have left the low-yielding safe stuff, such as 10-year Treasurys (currently yielding 2.6 percent), to find greater yield in other types of bonds, such as foreign or junk bonds.

"A merger arbitrage strategy invests in the small price variance that often exists during the time period between when a merger is announced and when it closes."

What if there were other options we could consider in a low-yield environment? Forget for a moment that we are looking to satisfy a bond allocation and, instead, approach this question by looking at what we seek from the non-stock allocation of our portfolio. Our criteria may include an investment strategy that offers:

  • Low to mid single-digit returns.
  • Low volatility.
  • Low correlation to other parts of the portfolio.
  • And for now, let's throw in an avoidance of interest-rate risk. If interest rates soar and our other bonds get hit, we'd like for this part of the portfolio to act independently.

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If we look outside the "bond box," we see that this investment does exist among the alternative category; it's called merger arbitrage. Before you move on due to the fancy name, hear me out. And keep in mind that the specific no-load funds I mention are not some "fly by night" investment but have track records going back more than a decade.

A merger arbitrage strategy invests in the small price variance that often exists during the time period between when a merger is announced and when it closes.

Merger arbitrage an option

As an example, when company A announces the purchase of company B for $50 a share, with the deal closing in three months, company B might today trade at just $48, only partially reflecting the final merger price of $50 per share.

This is due to the risk that the announced merger may not go through, as well as the time it takes for the merger to close. That creates a spread of $2 in this case—$48 paid vs. the $50 expected in three months—for an expected return of 4.1 percent. Merger arbitrage looks to earn this small spread repeatedly with multiple deals each year.

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To be successful in the strategy, a manager doesn't need more merger announcements, just for the majority of deals to close as expected, with fewer surprises.

The two merger arbitrage funds with the longest attractive records are the Merger Fund and the Arbitrage Fund.

The 25-year-old $5.6 billion Merger Fund invests most of its assets in larger merger deals concentrated primarily in North America.

The $2.5 billion Arbitrage Fund invests in fewer deals, with a greater portion in foreign transactions. This creates the potential for greater volatility and possibly higher returns.

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What I like so much about these strategies in today's market environment is they have experienced similar volatility to the aggregate bond index, with little bond correlation (sensitivity to bond-price movements).

When we examine the worst recent time period for stocks and bonds, these funds provided, in my opinion, an acceptable return and risk.

Merger arbitrage funds vs. stocks/bonds

Total Return 2008
Total Return 2013
Arbitrage Fund (ARBNX) -0.6 1.2
Merger Fund (MERFX) -2.3 3.6
S&P 500 Index -37 32.4
Barclays Aggregate Bond Index 5.2 -2

While this may seem like a brilliant risk/return strategy to diversify a bond portfolio, it does not come without risks.

As an example, the French government recently required a number of critical changes before General Electric was "allowed" to buy Alstom, a French multinational company that holds interests in the electricity generation and rail transport markets.

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So far, these two funds have navigated the above stated challenges quite well. In 2013 their returns, when compared to stocks, may seem paltry, but when compared with the negative returns of bonds, they did quite well.

With bond yields currently so low, perhaps these no-load solutions might find a place in your portfolio.

—By Barry Glassman, special to CNBC.com. Glassman is founder and president of Glassman Wealth Services.