Bond Alternatives May Be a Good Idea Right About Now

Most people think bonds are safe, but in today’s volatile climate, they are not.

In the not-too-distant past, bonds were portrayed as a secure part of a portfolio – a safer investment than stocks. Investors looked to government bonds as the bedrock of a stable retirement income. But bond yields are extremely low these days, prompting some investors to seek alternatives. This has sparked renewed interest in various investments that can generate passive income and stability.

Most people don’t remember what a bad bond market looks like because we haven’t seen one for 30-plus years! We’ve had steadily declining interest rates since the mid-1980s. Bond prices move in the opposite direction of interest rates. If interest rates rise, bond prices fall, and vice versa. The Federal Reserve has indicated it will be raising interest rates in 2022 and slowing its purchase of bonds, so the climate is likely to be less favorable for long-term bonds going forward. And with bonds paying historically low interest rates, long-term bonds falling in price could mean a low-yield investment for years.

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The problem with bond mutual funds

Bonds issue at par value of $1,000, and you are in effect loaning a corporation or some form of government your $1,000. There is a length of time you have to leave it there, until it reaches what is known as its maturity date, which can range from one year to 40-plus years. There will be a set interest rate for that length of time. So, if interest rates rise and bond prices fall, you can hold until maturity and get your $1,000 back.

A huge issue is that most people don't hold their bonds directly anymore; rather, their bonds are in mutual funds. And within mutual funds, there are two problems: There is no set interest rate, and there is no maturity date. So when interest rates rise and your bond prices fall, there is no date in time when you will get your $1,000 back.

Three other investments to consider instead

To avoid getting trapped while the outlook on bonds is not all that bright, here are some alternatives that can provide more security and a decent rate of return:

Fixed annuities and fixed index annuities

Fixed annuities, sold by insurance companies, offer long-term tax-deferred savings and monthly income for life. They involve an upfront payment by an investor for a series of guaranteed income distributions from an insurance company. The insurer guarantees the buyer a fixed interest rate on their contributions for a specific period of time. The value of the buyer’s principal, even if interest rates rise, stays the same.

You can also choose a fixed index annuity, where your principal is protected and the return is tied to a market index, like the S&P 500. If the market is down, the worst you can do is zero (zero is the hero), and it will have a participation rate on the upside. So as an example, if we have a 50% participation rate and the S&P 500 is up 12%, then 6% would be credited to your account on your anniversary date, and that new value is locked in and can’t drop below that value because of a market decline.

Annuities often generate more income than bonds of similar maturity purchased at the same time. Only the annuity’s return on investment is taxable, while the premium portion of each payment is returned tax-free. Bond income is completely taxable. And because annuities aren’t priced daily in an open market as bonds are, they are better than bonds at holding their value while generating a more predictable cash flow.

Buffered or defined-outcome ETFs

Buffered or defined-outcome exchange traded funds (ETFs) offer investors protection from severe dips in the stock market. They are seen as solid alternatives to bonds because they allow more access to various investment products. In many portfolios, bonds traditionally served as a ballast, helping offset the risk of equities. But with interest rates so low, buffered/defined outcome ETFs are replacing bonds in some portfolios.

These ETFs set an exact percentage in losses – 9%, 10%, 15%, 20% or 30% – that shareholders are protected from over a 12-month period. In exchange for limiting an investor’s downside, some of the gains are capped at 10%, 15% or 20%.

Most buffered/defined outcome ETFs are linked to the S&P 500 Index and use flexible exchange options (FLEX), which allow both the contract writer and the purchaser to negotiate different terms.

Real estate investment trusts

This is the best-known bond alternative, created in the 1960s to provide investors a way to invest in funds that own, manage and/or finance income-generating real estate. The REIT investment space is enormous; investors can target specific real estate segments and diversify across different segments. They get 90% of the profits.

REITs are tax-advantaged as dividends and trade like stocks. And unlike bonds, which pay a fixed amount of interest and have a set maturity date, REITs are productive assets that can increase in value indefinitely. Many REITs have dividend yields between 5% and 10%. Be careful though – many REITs are not liquid if you need access to your money in the short term.

Alternatives to bonds do offer higher yield potential. But remember – that comes with risk. It’s wise to work with an adviser to go over your options as you assess your portfolio. Differentiate between safe and risky assets, and structure your portfolio in a way that makes the most sense for you.

Dan Dunkin contributed to this article.