When I started working in capital markets 20 years ago, an investor seeking a “safe haven” could purchase a 30-year Treasury bond yielding better than 5%. The high-quality corporate bonds that I bought for my employer (a major life insurance company) often paid more than 7%.
Times have certainly changed. For much of 2020, 30-year Treasury bonds were paying in the mid-1% range, though they have since climbed to a “lofty” mid-2% level. A corporate bond buyer is lucky to get 4% today for lending money to an investment-grade American company.
Today’s flat bond yields pose a two-fold problem for retirees and those approaching retirement. First, investors buy bonds to generate steady income to fund spending. Second, bonds serve as a means of hedging, or offsetting, the risks associated with stock ownership. That is, when stocks are flagging in a market downdraft, bonds generally tend to do well as investors move away from riskier investments in a “flight to quality.”
So, are bonds still capable of playing either an income or a hedging role in a retirement portfolio these days? In a word, “yes,” though probably a smaller one than they have historically.
As I survey the investment landscape for sources of income generation and diversification outside of the bond market, a few options stand out:
- Credit Real Estate Investment Trusts
- Hedged equity strategies
- Volatility trading strategies
- Lower-risk stocks, plus cash
Credit Real Estate Investment Trusts
A credit real estate investment trust (REIT) holds a portfolio of residential or commercial mortgages, which make regular interest payments, as would a bond fund. Because most of the portfolio consists of private loans, rather than public bond issues, the yields tend to be several percentage points higher. Further, because of accounting rules, these privately issued loans are carried at cost, rather than market value, and exhibit much less price volatility than typical bonds do. Credit REITs can, therefore, serve as both an effective income and diversification vehicle.
Hedged Equity Strategies
Hedged equity strategies consist of stock portfolios whose downside risk is mitigated by the use of derivatives, such as put options. Depending on how the options are structured and/or offset by the sale of other options, the cost of the stock portfolio “insurance” can be lower than the “insurance” created by a bond allocation.
Volatility Trading Strategies
Volatility trading strategies seek to either:
- generate income by selling volatility (as implied in stock option contract prices), or
- benefit from an increase in volatility, which tends to spike when stock prices dive.
Careful attention is required to successfully implement a volatility strategy, particularly given the proliferation of exchange-traded funds that are highly susceptible to adverse market movements. Nonetheless, “volatility as an asset class” can be a very effective portfolio diversifier if you know what you are doing.
One can also greatly reduce the risk of a stock portfolio without introducing bonds, but simply by skewing the mix of stock holdings towards less volatile companies.
Consider a Classic Portfolio: A “60/40” portfolio that holds 60% in stocks and 40% in bonds generates a dividend & interest income yield of 1.6%, with 10.3% annualized volatility.
Consider an Alternative: A portfolio comprised of 80% stocks, evenly split between the consumer staples and utilities sectors, and 20% cash, yields 2.2%, with 10.9% annualized volatility.
Even though it has 20% more allocated to stocks, this 80% stock portfolio has comparable volatility to the 60/40 model above.
In practice, I would not advise holding a two-sector stock portfolio, but the preceding example is a useful illustration of how much a given stock portfolio’s volatility can differ from another’s, based on the riskiness of the individual holdings.
Understandably, unfamiliarity with the above “bond alternatives” strategies may cause some investors to shy away. However, each of them has a sound theoretical basis and sufficient track record to warrant serious consideration. If nothing else, a world where risky bonds paying only 5% are considered “high yield” should make investors rethink their approach.
About James Adams, CFA, CFP® and BSSF Wealth
BSSF Wealth is a fee-only financial planning firm headquartered in Camp Hill, Pennsylvania, with additional office locations in Hanover and Lancaster, as well as Frederick and Westminster, Maryland. BSSF Wealth is a Member of Advisory Services Network, LLC.
James Adams (“Jimmy”) is a Private Wealth Advisor at BSSF Wealth, which he co-founded in partnership with Brown Schultz Sheridan & Fritz (BSSF). He has two decades of financial services experience with expertise in asset allocation, portfolio analytics, financial planning, and investment manager selection. He is also the author of Waffle Street, a memoir of his time spent at a Waffle House in 2009 after the market collapse in the Global Financial Crisis. The book was later adapted into a feature film of the same name, starring James Lafferty and Danny Glover.
Disclosures: Investment Advisor Services offered through BSSF Wealth, a member of Advisory Services Network, LLC. Tax preparation services offered through Brown Schultz Sheridan & Fritz. Advisory Services Network, LLC and Brown Schultz Sheridan & Fritz are not affiliated. Advisory Services Network, LLC does not provide tax advice. The views expressed herein are those of BSSF Wealth and not necessarily those of the Advisory Services Network, LLC. This material is for informational purposes only and does not give personalized investment or professional advice. This is neither a solicitation, nor a recommendation, to purchase or sell an investment and should not be relied upon as such. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law or any other matters that affect you or your business. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment loss. As with any investment strategy, there is the possibility of profitability as well as loss. The strategy discussed above is for illustrative and educational purposes only and should not be construed as an endorsement, recommendation or solicitation to buy or sell any particular security. Options involve risk and are not suitable for all investors. Certain complex options strategies carry additional risk. Please read the options disclosure document titles Characteristics and Risks of Standardized Options by clicking on this hyperlink text https://www.theocc.com/about/publications/character-risks.jsp before considering any options transactions. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received.