The Best Bond Alternative No One Is Talking About

What is the job of a bond in your portfolio? When you think about it, bonds have two primary roles in a well-balanced portfolio.

Role #1 is to provide steady income. Role #2 is to provide stability for a portion of your principal to offset some of the volatility of market positions. How are bonds doing in fulfilling those roles in today's environment?

When it comes to steady income, bonds are currently grading out at a D. Due to low interest rates, you are receiving almost no income from your bond positions, unless you venture into high-yield bonds, which are a euphemism for junk. Investment-grade bonds are paying very little.

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In regards to providing stability to your portfolio, bond prices are at all-time highs. Bond prices move inversely with interest rates. What will happen to the value of your bonds when interest rates rise in the future? They will decline. Buying bonds today is the equivalent of buying high so you can later sell low. Not a great idea.

What else can you do?

Imagine for a moment that you could go out on the market today and buy a 10-year investment-grade bond with the principal insured paying a coupon rate of 4%. Would you buy that bond? If you are like most people, you would jump all over it and hold it for the next 10 years happily.

That hypothetical bond would fulfill both roles of a bond admirably. Unfortunately, no such bond exists. However, something very similar does exist if you broaden your horizons.

If you are willing to expand your thinking just a bit, you will find that insurance companies have a few fixed indexed annuities that actually work similarly to our hypothetical 10-year 4% bond.

For many of you, you simply need to get over the word "annuity."

Warning: Very Few Qualify

Please be aware that out of the thousands of fixed indexed annuities very few will actually produce a 4% return over the next 10 years.

One fixed indexed annuity approach that we are currently using as a bond alternative: As of this writing, two highly rated companies have a 10-year fixed indexed annuity that pays interest equal to 35% of Standard & Poor's 500-stock index when it is up for the year, and pays 0% when that index is down for the year.

In other words, if the market is up, you get 35% of the upside. If it is down, you get 0% for that year. Each year during the 10 years is evaluated separately when calculating interest.

If you do any kind of research, you will find that this approach will very likely net you between 3% to 6% annual returns in almost any 10-year period. Your principal is insured, and you receive returns closer to what you want your bonds to pay.

Of course, fixed indexed annuities come with disadvantages. The two biggest are that you will pay surrender charges if you exit out of the annuity completely during the contract period, and the earnings are not guaranteed.

If you cannot stomach an annuity, you can also look into the world of limited partnerships, as there are options for alternative income. But buyer beware: These can look very good on the surface, but the liquidity is often very limited.

Don't be afraid to think outside the box in today's low interest rate environment. You need to evaluate new solutions to today's new problems.

Michael Reese, CFP®, CLU, ChFC, CTS is the founder and principal of Centennial Wealth Advisory, LLC with offices in Austin, Texas and Traverse City, Michigan. His focus is to help retirees enjoy financial security in any economy.