In the October issue of Global ETF Profits, we swapped out of our position in Market Vectors Pre-Refunded Municipal Bond (NYSE: PRB) in favor of Market Vectors Intermediate Municipal Index (NYSE: ITM). That decision was driven by the fact that state and local balance sheets, while still under strain, were clearly on the mend so it was prudent to assume more risk. Additionally, the Federal Reserve has committed to maintain its current interest rate policy through mid-2013, so it should be fine to take on greater duration risk in order to realize higher yields.

Since then, that decision has played out in our favor, as Market Vectors Intermediate Municipal Index has outperformed Market Vectors Pre-Refunded Municipal Bond by more than 3 percentage points while paying out almost twice the yield.

A similar rationale is driving our outlook for fixed-income securities in 2012: Improving economic conditions will warrant pursuing additional risk next year.

US government bonds have been the best-performing asset class this year with the Barclays Capital Long Term Treasury Index gaining more than 20 percent. That performance is reminiscent of 2008, when panic gripped the markets as the US struggled with its own credit crisis. Given the magnitude of the problems in Europe, investors were desperate for a margin of safety.

But 2012 should turn out differently.

First, we expect material steps to be made in addressing the European sovereign-debt crisis. The simple fact that most of the European Union member nations–with the UK being the notable exception–were able to agree that greater fiscal unity was a necessary step toward a sustainable euro shows that they appreciate the magnitude of the challenges they face. Of course, it remains to be seen whether the deal will unravel when facing the scrutiny of voters and politicians in each member nation, but at least the heads of state understand the steps that have to be taken.

So while the ultimate resolution of the debt crisis is still some months away, continued progress in that arena will help restore investor confidence.

Additionally, there’s the matter of the flattening Treasury yield curve.

Over the past three years, the curve has flattened to the point where investors are accepting virtually no return in exchange for a safe haven. Since yields can’t decline any further, the yield curve has to steepen at some point, and we think that will likely happen this year despite the Fed’s commitment otherwise.

And we believe Federal Reserve Chairman Ben Bernanke understands that reality.

A recent meeting of the Federal Open Market Committee (FOMC) included a discussion about changing the way the Fed communicates its interest rate policy to investors. Until recently, the Fed was famously vague about its expectations for future interest rates, largely as a strategy to allow wiggle room in case the economic situation changed. The Fed’s specificity in stating how long it expects to maintain its current interest rate policy is a new approach.

That specificity came about largely as a way for the Fed to manage interest rates without having to commit as many dollars to the process. If investors expect the Fed to stand behind its rate policy for a specified period of time, the markets are less likely to move against it.

However, we suspect the FOMC discussion about the Fed’s communications strategy likely revolved around how to reclaim some of that flexibility in policymaking.

With the US economy on the mend, an assessment that nine of the 10 members of the FOMC were in concurrence with after the last meeting, the Fed’s overt approach to communications strategy may have already achieved its end. And since the Fed was woefully behind the curve in addressing the last debt bubble–and arguably was a contributing factor to that bubble after maintaining interest rates at levels that were too low for too long–it may be looking for a way out of its current pledge to maintain low interest rates.

While we don’t expect rates to skyrocket any time soon, we do believe the yield curve will begin to steepen in the coming months. So it’s prudent to put on a hedge to help insulate our Portfolio from that possibility.

iPath US Treasury Steepener ETN (NYSE: STPP) is the best way to play a steepening yield curve.

The exchange-traded note’s (ETN) underlying index tracks the spread between 2-year and 10-year Treasury futures; when the spread widens, iPath US Treasury Steepener ETN gains in value.

While we’re generally leery of these more esoteric investment products, iPath US Treasury Steepener ETN appears to function precisely as designed. It also charges a reasonable 0.75 percent annual expense ratio, which is at the lower end of the range for specialty exchange-traded products.

iPath US Treasury Steepener ETN, the newest addition to our Income & Hedges Portfolio, rates a buy below 45.

In addition to adding this latest hedge to our Portfolio, we’ll be looking to add some additional risk to our fixed-income holdings in the coming months.