Alternatives to Bonds and Fixed Income
Bond alternatives are an interesting consideration give the low interest rate environment.
If you have de-risked from your accumulation portfolio, you likely have quite a bit of money invested in bonds. Are there any alternatives to bonds worth considering?
Fixed income, as an investment class, includes bonds and other assets. What are the options for fixed income investing and what are the alternatives to bonds one may consider?
Why have Bonds in Your Portfolio?
Before we begin, why do you have bonds in your portfolio?
Bonds do three things:
They provide ballast to the portfolio price stability. Most of the time, you expect return of your principle at the end of the term
Bonds pay out twice a year until maturity. Interest rates are currently low, which is why some people are seeking bond alternatives
Bonds are less correlated than other asset classes with equities. When the stock market takes a hit, often times bonds increase in price which can offset the losses depending on your asset allocation
So, why have bonds? Instead of worrying about income, think about ballast and diversification. Fixed income investing is not about income anymore!
Fixed Income Investing is not about Income
Not infrequently, those in retirement seek to replace their biweekly income. Retirement planning, after all, is all about creating retirement income from your assets.
Should you try to pay for the expenses during retirement via dividends and other income from your portfolio? No! I argue income is not necessary from your retirement portfolio; it is total return that is most important. Let’s not get into the discussion about yield vs. total return too much here. Suffice it to say that, for the most part, they are two sides of the same coin.
Focusing on yield, however, can lead to yield chasing. Chasing yield implies you are taking on more risk than your realize because you believe you need to creating income with your portfolio.
Do not chase risk! Take risk in your risky assets and be safe with your safe assets!
Chasing yield is dangerous. Increasing risk to get income is a losing proposition.
Bonds are not for yield, they are for protection.
Not everyone will agree with me. That’s fine, but consider what risk you are taking in your portfolio and if you need to take that risk to meet your goals in retirement. If you need risk to meet your retirement goals, then we have other issues to worry about.
Let’s transition now and discuss the basics of fixed income. What are your options when it comes to the bonds portion of your portfolio?
Fixed Income Options
Short-term, these treasury bills mature within one year and do not pay coupons. You buy the bill at a price less than its face value and earn that difference at the maturity.
Notes mature between 2 and 10 years and usually have a $1,000 face value.
Similar to the T-notes except treasury bonds have longer maturities, up to 30 years.
TIPS (Treasure Inflation-Protected Securities)
The principal adjusts with inflation and deflation, thus protecting you from inflation. Coupon payments tend to be lower with TIPS.
Backed by a state, municipality, or county to finances capital expenditures. Muni bonds offer federal tax-free payments, and they can be tax free in your state as well.
A loan to a company, the price and interest rate depends on the company’s financial stability. If the corporation goes under, you can suffer risk of your principle.
High Yield Bonds
Also known as Junk bonds, these have a higher risk of default thus pay extra.
Certificate of Deposits are fixed income offered by banks that have FDIC protection.
Fixed-Income Mutual Funds or ETFs
Finally, most of the above products can be wrapped into a mutual fund or ETF
So, if you are not interested in chasing yield, but instead want the other benefits from fixed income, what to do? Remember, diversification through decreased correlation with the stock market and ballast to limit losses on your portfolio is the name of the game.
What are options for bond alternatives? Consider real estate, insurance products, and some miscellaneous ideas. In effect, the question you want to answer: what is your product allocation?
Real Estate as Bond Alternatives
First off, if you owe money via a mortgage, paying your mortgage off may be the best bond alternative out there!
This is because debt is like a negative bond. As you pay off debt, you increase your exposure to bonds. Another way to say this: if you own equities yet are in debt, you are using leverage to buy those equities. You may have more risk than you think!
REITS are another alternative to bonds. REITS do pay more income than bonds, but tend to act like equities and be very volatile when the market is also volatile. Most folks consider REITs part of their equity allocation, though you could include it as your real estate allocation or even as a type of bond alternative.
Real estate can also be a bond alternative either through active or passive investments. This is a broad subject. Entire websites are devoted to delving into the intracacies of real estate as an alternative investment.
Insurance Products as Bond Alternatives
Insurance products offer risk pooling and are a strong consideration as a bond alternative. You can chose from life insurance and annuities.
Permanent Life Insurance
There are many different types of permanent life insurance, and you should probably stay away from these complicated and expensive products unless you have a specific need for permanent life insurance.
What are your options?
Whole Life Insurance
Whole Life is the best insurance option as a bond alternative. This is because Whole Life is actually truly non-correlated with stock market returns. Thought the return on investment may be low, there is a guaranteed return on whole life and the ability to make extra returns through paid up additions and dividends on the mutual company. If you seek diversification from stocks and bonds (and you have a need for permanent life insurance), explore options in Whole Life insurance.
Universal Life is NOT as good of a bond alternative as Whole Life. This is because, first off, variable universal life invests in equities. Sure, there are “guaranteed” returns in your fictional account that may be tied to income riders, but, man, that gets my head spinning with complexity. Next, Fixed Indexed products depend on fixed income for the floor. Why not just own the fixed income yourself? Options on equity returns allow for the “extra” return that salesmen pitch. Well, if interest rates are low, there is not much extra to pay for the options, so expect caps and spreads (which can be changed at any time by the insurance company) to go down with decreasing interest rates. If you are going to invest in a Fixed Indexed Life insurance product, you might as well use a structured product.
Structured Products are complicated and should not be used as a hedge. These are not good alternatives to fixed income. Speaking of complexity, try to actually understand one of these products.
Annuities as Bond Alternatives
Annuities are strong contenders as fixed income alternatives. Unfortunately, there are many different types!
Single Premium Immediate Annuities can be used to provide floor income and thus obviate the need for bonds. They are a strong contender as a bond alternative.
Deferred income Annuities offer longevity protection. Consider a QLAC if you have a large IRA. Otherwise, annuities are affected by interest rates so DIAs are not screaming deals right now.
Multi Year Guaranteed Annuities are also interesting, but subject to low interest rates as well. If you are considering a bond ladder, consider MYGAs as rungs in your ladder. I think more traditional DIY investors should get to know MYGAs. These products are not sold to you, you have to go out looking for one to buy. If you have money you need back in a few years, consider a MYGA instead of leaving the money instead of a high yield savings account. Of course, you need to be 60 to avoid a 10% penalty for “early withdrawal” in these products.
Fixed Indexed Annuities may be a decent alternative to bonds. However, buyer beware, and prepare to spend many hours understanding these complicated and expensive products. Income riders can offer bond-like annuity or non-annuity income for future income needs. If you know you want income in the future from an annuity, a FIA is a consideration. Buyer beware, however, as these may suffer from low caps and high spreads given low interest rates.
Variable Annuities are garbage and should not be considered as bond alternatives. There, I said it.
There are other insurance products such as viatical settlements, reinsurance, etc that are also possible fixed income alternatives. If you want those, be ready to deal with risk with a side of illiquidity.
Pensions are a great alternative to bonds. If you have a pension, you can view that as part of your floor expenses, and reduce your bond exposure accordingly.
Social Security is perhaps the best bond alternative. Understand how to Maximize your Social Security and have guaranteed, lifelong income that is better than any fixed income alternative.
Misc. Consideration for Bond Alternatives
Preferred Stock- Likely as risky as stocks when the market is headed down, but not infrequently used for income.
Managed Payout Funds – Also, likely to be avoided as they trade thinly. Did I hear that Vanguard is getting rid of theirs?
Additional considerations include: Floating Rate Loans, Private Equity, Senior Loans, Mezzanine debt, Farm land, raw land, timber, Commodities, Gold, Hedge Funds, and Private Equity. Oh my.
Farm Land is a really interesting bond alternative that you should consider.
Finally, I am invested in investment grade wine as a bond alternative.
Conclusion Bond Alternatives
So, what is the best alternative to bonds?
There is nothing equivalent to a good asset allocation for retirement.
When you have won the game, go conservative.
If you must invest in alternatives to bonds, remember, don’t reach for yield. The point of fixed income is the stability and diversification. Don’t become mired on the mirage of income!
Real estate, income annuities, and perhaps Whole Life insurance might be your best bet for uncorrelated returns. Farmland and Wine are interesting possibilities.
Never forget about pensions and social security, which are bond alternative gold.