Why Might Bonds Not Work For Some People?
Historically, bonds have been a staple for income-focused investors and a fundamental aspect of many retirement portfolios. These fixed-rate loans provide a predictable source of income and serve as a stabilizing force during times of economic stress.
While they are still an important asset class and can be a valuable aspect of your personal finance strategy, bonds have lost much of their luster since the Great Recession. Persistently low interest rates and indications of diminished diversification benefit have prompted many investors to seek higher-yielding alternatives.
Alternative Investments to Bonds
Bonds will always serve a useful purpose for conservative investors, but there are a variety of other assets that can enhance the yield of a traditional portfolio. That said, these alternatives may exhibit more volatility, less liquidity and greater complexity than bonds. Before investing in them, you should carefully consider how their advantages and disadvantages could impact the aggregate performance of your portfolio.
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- Certificates of Deposit
- Certificates of deposit (CDs) are stable value savings accounts offered by banks and credit unions to their customers. These products tend to offer higher interest rates than traditional savings accounts, but they entail varying lock-up periods — the set windows of time in which you may not sell.
Unfortunately, given the challenging interest-rate environment, most CDs offer paltry yields regardless of the lock-up period.
- High-Yield Savings Accounts
- Compared to CDs, high-yield savings accounts offer similar stability with much greater liquidity. A good high-yield savings account will help you to grow your funds more quickly than with a traditional savings account. Online banks often offer the highest percentage yield savings accounts.
- Bank Loans
- Bank loans are floating-rate instruments that serve as diversifiers to fixed-rate bonds. They are less exposed to interest rate movements and offer fairly high yields. Be aware that they are issued by non-investment grade companies, which entails a relatively high degree of credit risk. You can mitigate risk by investing in senior loans secured with sound collateral.
- Private Credit
- Private credit consists of debt arrangements extended directly to small- and medium-sized businesses, without the involvement of financial institutions. This can include secured or unsecured floating-rate loans and fixed-rate bonds with varying degrees of seniority.
The private nature of the arrangements can provide investors with the ability to mitigate some credit risk via special terms and covenants, but it also makes these investments rather illiquid. When choosing this alternative, skilled management is essential.
- Preferred Stocks
- Preferred stocks are hybrid securities, sharing characteristics of both common stocks and bonds. They offer higher income than conventional stocks, while exhibiting a level of price volatility that falls somewhere between that of stocks and bonds. Preferred shareholders outrank common shareholders for claims on the earnings and assets, but their claims fall below those of bondholders.
- High-Dividend Common Stocks
- These equity investments focus on income rather than price appreciation. In this respect, they resemble bonds. While the risk profile of stocks differs greatly from that of bonds, high-dividend paying stocks — which include stocks from well-established companies in the utilities, telecommunications and consumer staples sectors — are bond-like.
- Real Estate
- Commercial real estate investments can be another significant source of income. However, the average investor has neither the cash nor the time to purchase and manage a diversified portfolio of properties.
Fortunately, exposure can be achieved via real estate investment trusts (REITs), which are tax-advantaged as dividends. They allow you to invest in funds that own, manage, and/or finance income-generating real estate — often, for less than $100 per share. They are highly liquid and trade just like stocks.
The REIT investment space is enormous. Many are highly diversified, but some vehicles target specific geographic regions and sectors of the market, including apartment buildings, retail centers, office buildings, hotels, medical facilities and data storage centers.
- Fixed Annuities
- Fixed annuities are tax-advantaged financial contracts sold by insurance companies. They can be structured in myriad ways with a variety of features, but all fixed annuities share a fundamental similarity. They involve an upfront payment by an investor for a series of guaranteed income distributions from an insurance company.
- Other Questionable Asset Classes
Beyond the asset classes described above, some people are quick to classify other high-dividend paying investments as bond alternatives. At the top of many lists are master limited partnerships (MLPs) and business development companies (BDCs).
While both of these asset classes can provide a high degree of income, they can also be extremely volatile. This aspect is very unlike the stability of a bond; a good bond alternative should offer some degree of price stability in addition to a predictable source of income.
Alternatives to Bonds
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When Bonds Are the Right Choice
Despite the challenging interest rate environment, bonds remain an important asset class for conservative investors, especially retirees. Aside from high-yield savings accounts, few assets offer the liquidity and stabilizing benefit of a high-quality bond.
Many of the alternatives offer the potential for additional yield, but that potential comes with risk. Remember this as you assess the structure of your portfolio.
Strive to maintain a clear understanding of your risky assets and your safe assets, and do not be tempted to chase yield imprudently. Doing so could put your hard-earned savings at risk.