At its core, a bond is a loan. As investors, we can lend some of our money out to a qualified borrower, whether it’s a corporation or a government entity, and in exchange, we get a promise—a promise that the money lent out will be repaid at a later date, plus some interest.
Despite staying out of the limelight commanded by other assets (such as stocks), bonds are a valuable part of many investors’ portfolios. Their value not only comes from the interest that can be earned, but also from the promise to get your original investment back. While this promise is by no means a guarantee, as investors, if we lend our money to creditworthy borrowers, we stand a very reliable chance of getting our money back. Often, the more important value that bonds offer investors is just this: reliability. Although reliability may be far less glamorous than 10x returns, it can offer an essential balance for many investors—and bonds work behind the scenes to make a portfolio more resilient.
Where bonds can sometimes be misunderstood is in their relationship to interest rates. Bonds have an inverse relationship to changes in interest rates: in other words, when rates go up, the resale value of existing bonds goes down—and when interest rates go down, the resale value of existing bonds goes up. But despite what interest rates do, bonds that are held to maturity will continue to earn their stated interest rate and will be repaid (barring a catastrophe).
This relationship between interest rates and bonds comes to the surface at moments in time when interest rates are rising. Many investors may naturally be drawn to make a reactive decision based on the possibility of rising rates, and any dips in the value of your bonds may have you wondering if there are any trustworthy bond alternatives worth exploring. So let’s take a look at some key characteristics of bonds, and consider some pros and cons of possible alternatives to bonds.
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What Roles Can Bonds Play In a Balanced Portfolio?
The long story short is that there are alternatives to bonds that may offer some similar characteristics. But we don’t recommend abandoning all your bonds in a dash to scoop up other financial positions, because there may be important trade-offs. The key is to proceed with a clear head and a comfortable understanding of all the relevant facts. So here’s a look at some of the key roles bonds can play in a balanced portfolio:
- Bonds can be volatility dampeners. Because of how they’re constructed, bonds are incredibly reliable—like the ballast on a ship. Steady and remarkably resistant to sharp market drops, they can help your portfolio weather tough economic times, and they make great “rainy day” (or month, or year) investments. In particular, bonds historically have either been down far less than stocks or even up in value during periods of time where stocks are down sharply.
- Bonds provide liquidity opportunities. Bonds, as less volatile investments, are essential for many investors who need regular income from their portfolios. Not only are your bonds paying you interest, but they can create essential opportunities for rebalancing a portfolio to raise cash during periods of time when other assets are down in value. They can provide a steady income to investors looking for a reliable investment payout.
- Your bond interest rate is set when it is purchased. You can rely on the rate of interest you’ll receive back when your bonds mature. Your bond interest rate(s) are set at the time you purchase (with some exceptions), so you don’t have to wonder if your rates will fluctuate with the market or other investments (as long as you wait until your bond matures).
- Your income taxes can potentially be reduced using bonds. If you own government bonds and/or municipal bonds—especially bonds associated with the state where you live—you can use bonds to shield your hard-earned money from federal or state income taxes in some cases.
- You can diversify bonds via mutual funds and ETFs. One last advantage of bonds is their flexibility to be purchased individually or in a diversified type of investment such as a mutual fund or Exchange Traded Fund (ETF). These types of funds can own hundreds of bonds at one time and constantly buy and sell them to achieve the best rate of return for you. If bond interest rates start to go up, the funds will be able to buy new bonds at ever higher interest rates. So while the current value of the existing bonds in a fund may temporarily go down in value in rising rate environments, at the same time, the yield rises as the fund buys new bonds at the new, higher rates.
When Bond Alternatives Make Sense
While bonds provide helpful padding, some investors may still want to explore alternate ways of safeguarding their cash.
After all, bonds can also force investors into playing a long game: If you hold an individual bond for the full term, you’ll get your money back plus the full interest rate you locked in at the original point of purchase. But if, halfway through the bond term, you decide to sell your bond to another investor, you may be subject to a change (whether good or bad) in your return, depending on how attractive your locked-in rate is to potential buyers.
NOTE: Before considering any alternatives to bonds, first consider a few questions: What types of bonds do you own in your portfolio? Individual bonds, mutual fund bonds, ETF bonds, or something different? And why do you own them?
For most investors, bonds provide a certain level of reliability, fixed income opportunities, and protection against long-term inflation. With those goals in mind, we’ll list three alternatives to bonds that can accomplish some similar objectives.
1. Dividend-paying Stocks
On the surface, dividend stocks are a logical swap for bonds. They have a historic track record of paying out earnings rather than holding onto them. Dividend-paying stocks can create a meaningful replacement for bonds by providing you with a regular payoff. Utility companies, like water and gas, are popular dividend-payers that often provide a reliable income similar to bond returns. Tradeoffs to consider include:
- The shift may add more risk to your portfolio.
- Purchasing these stocks may limit your diversification, because only about half the U.S. market is composed of consistently high dividend-paying stocks.
- Dividend-paying stocks don’t have to pay dividends—in a market downturn, companies may choose to stop paying.
- Replacing bonds with more stocks in a portfolio may reduce rebalancing opportunities.
2. Real Estate Investment Trusts (REITs)
These are funds that purchase large amounts of real estate holdings. These types of funds are technically equities, and they usually provide a reliable income to owners. With REITs, you’re buying an ownership share in real estate instead of loaning your money out (as with bonds). So, on the positive side, you’re entitled to all real estate earnings along with other part-owners. However, be aware of the tradeoffs:
- REITs are volatile, opening you to greater risk and uncertainty (as well as greater potential for return).
- Your part-ownership comes with responsibilities, meaning you’ll face any real estate market troubles along with the company that owns the REITs.
3. Cash Alternatives
In lieu of bonds, you can place your cash in a high-yield savings account. As interest rates rise, you’ll get the higher interest rates that become available. In these types of accounts, the yield on cash is going to move upward at a higher rate than a typical bank savings account. Some pitfalls to consider here:
- These accounts will multiply your cash, but interest rates are usually less than what is available with bonds.
- In a high-inflationary environment, you may still lose purchasing power by keeping money in these accounts.
NOTE: Another creative alternative: Simply purchase different bonds. Some investors may consider switching their longer-duration bonds to ones with a shorter duration. This reduces the bonds’ sensitivity to changes in interest rates, but it also reduces the yield on the bonds in the portfolio. Some investors may further diversify their bond holdings by pursuing different bond types like TIPS, or treasury inflation-protected securities.
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In the end, bonds are the ever-important unsung heroes of many portfolios. They have their place, as do other types of more volatile investments.
As inflation rises and the market ebbs and flows, we want to leave you with this piece of guidance: If the mix of bonds you own has been good for you thus far, it’s most likely still appropriate now.
Regardless, if you’re keen to explore bond alternatives or gain further guidance on the state of your portfolio, including bonds, contact the advisors at Bay Point. We have decades of experience and can help direct you toward wise, timely, and reliable investing, including diversification and rebalancing your portfolio.
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