Looking for a potential alternative to bonds? Look no further.
With the expectation for U.S. interest rate increases to come in 2015, many investors have been considering an alternative for the investment grade bond allocation in their overall portfolio. Before making any rash decisions, though, it may be worth reviewing the role these types of bonds typically play in a total portfolio context.
Investors typically look to investment grade bonds for potential
Sources: Russell as of 12/31/14. Legend: ?= meets criterion; blank = doesn’t meet criterion
Cash
Often, the first alternative offered up to replace bonds is cash and cash-like investments. After all, it has historically offered capital preservation and lower portfolio volatility. However, given the 0% – 0.25% target the Federal Reserve has set for short-term interest rates and assuming inflation remains above zero, the real return on cash and cash-like investments is negative. So cash is not likely a suitable replacement for bonds.
Admittedly, in the current low interest rate environment, bond yields are below their historical average as well. But even the modest yield on bonds has outpaced the negative real return on cash since 2008. That’s because the total return on a bond comes from two sources: price changes and coupon income. While true that bond prices go down when rates rise, coupon income remains intact (barring a default). So interest rate increases only affect one portion of a bond’s total return. In addition, bond returns have been historically derived mainly from coupon income and not price appreciation or loss. This coupon payment has provided a cushion of stability that has also helped protect against losses.
Sources: Bloomberg Live. Coupon Income is defined as the annual coupon payments paid by the issuer relative to the bond’s par value.
High-yield bonds and higher-yielding securities
Another alternative some investors have recently been opting for as a replacement for their modestly yielding investment grade bonds are high yield bonds and higher yielding securities (e.g. REITs, MLPs or high dividend-paying equities). However, we would caution investors when reaching for yield. The trade-off for this incremental yield is a significant degradation of quality and an increase in the overall risk profile of a total portfolio. If capital preservation is important to investors, we’d caution using high-yield bonds and higher-yielding securities as an alternative to investment grade bonds.
Commodities
Others still have been looking to commodities as a potential alternative to their investment grade bonds. Commodities have historically had a correlation to equities somewhere between investment grade bonds and REITs. However, as with the previous bond alternatives discussed, commodities have not demonstrated a level of capital preservation or low volatility characteristics comparable to an investment grade bond portfolio. One has to look no further than calendar year 2014 when the Bloomberg Commodity Index had a total return of -17.0%. That can be compared to the worst year the Bloomberg U.S. Aggregate Bond Index has experienced since its inception in 1976, of -2.9%. The historical lack of reliability of commodities’ capital preservation benefits also likely eliminate their suitability as a replacement for bonds.
Sources: U.S. Equity – Russell 3000® Index, High Dividend-Paying Equities - S&P High Yield Dividend Aristcrts TR USD, Developed REITs – FTSE EPRA/NAREIT Developed Index, Global High Yield Bonds - BofAML Global High Yield TR Hdg USD, Commodities – Bloomberg Commodity Index, MLPs - Alerian MLP TR USD, Cash - Bloomberg US Treasury Bill 1-3 Mon TR USD, Fixed Income – Bloomberg U.S. Aggregate Bond Index. Index performance is not indicative of the performance of any specific investment. Indexes are not managed and may not be invested in directly. Correlation is defined as a quantity between -1 and 1 that measures how two variables move in relation to each other.
- capital preservation
- diversification to equity risk
- lower total portfolio volatility
- a modest return (composed of current income and capital appreciation)
The nominees: potential investment grade bond alternatives?
Sources: Russell as of 12/31/14. Legend: ?= meets criterion; blank = doesn’t meet criterion
Cash
Often, the first alternative offered up to replace bonds is cash and cash-like investments. After all, it has historically offered capital preservation and lower portfolio volatility. However, given the 0% – 0.25% target the Federal Reserve has set for short-term interest rates and assuming inflation remains above zero, the real return on cash and cash-like investments is negative. So cash is not likely a suitable replacement for bonds.
Admittedly, in the current low interest rate environment, bond yields are below their historical average as well. But even the modest yield on bonds has outpaced the negative real return on cash since 2008. That’s because the total return on a bond comes from two sources: price changes and coupon income. While true that bond prices go down when rates rise, coupon income remains intact (barring a default). So interest rate increases only affect one portion of a bond’s total return. In addition, bond returns have been historically derived mainly from coupon income and not price appreciation or loss. This coupon payment has provided a cushion of stability that has also helped protect against losses.
Sources: Bloomberg Live. Coupon Income is defined as the annual coupon payments paid by the issuer relative to the bond’s par value.
High-yield bonds and higher-yielding securities
Another alternative some investors have recently been opting for as a replacement for their modestly yielding investment grade bonds are high yield bonds and higher yielding securities (e.g. REITs, MLPs or high dividend-paying equities). However, we would caution investors when reaching for yield. The trade-off for this incremental yield is a significant degradation of quality and an increase in the overall risk profile of a total portfolio. If capital preservation is important to investors, we’d caution using high-yield bonds and higher-yielding securities as an alternative to investment grade bonds.
Commodities
Others still have been looking to commodities as a potential alternative to their investment grade bonds. Commodities have historically had a correlation to equities somewhere between investment grade bonds and REITs. However, as with the previous bond alternatives discussed, commodities have not demonstrated a level of capital preservation or low volatility characteristics comparable to an investment grade bond portfolio. One has to look no further than calendar year 2014 when the Bloomberg Commodity Index had a total return of -17.0%. That can be compared to the worst year the Bloomberg U.S. Aggregate Bond Index has experienced since its inception in 1976, of -2.9%. The historical lack of reliability of commodities’ capital preservation benefits also likely eliminate their suitability as a replacement for bonds.
Sources: U.S. Equity – Russell 3000® Index, High Dividend-Paying Equities - S&P High Yield Dividend Aristcrts TR USD, Developed REITs – FTSE EPRA/NAREIT Developed Index, Global High Yield Bonds - BofAML Global High Yield TR Hdg USD, Commodities – Bloomberg Commodity Index, MLPs - Alerian MLP TR USD, Cash - Bloomberg US Treasury Bill 1-3 Mon TR USD, Fixed Income – Bloomberg U.S. Aggregate Bond Index. Index performance is not indicative of the performance of any specific investment. Indexes are not managed and may not be invested in directly. Correlation is defined as a quantity between -1 and 1 that measures how two variables move in relation to each other.