Bond dilemma requires new thinking

The case for bonds in investment portfolios has traditionally been compelling. With higher certainty of returns at lower volatility, they have been the stable cornerstone of portfolios, particularly over the last three decades, as bond prices appreciated on the back of a significant fall in interest rates. This great run, however, may be coming to an end.

Today, with interest rates at a practical floor and starting to rise, bond yields are struggling to meet investors’ income needs and bond prices are depreciating. In this environment, advisers have increasingly asked themselves: How do we replace low-yield bonds in a portfolio? A common reaction has been to move assets from bonds to riskier investments that deliver income, such as high-dividend-paying stocks, real estate investment trusts or master limited partnerships.

Income trap

To focus solely on income ignores the other key benefits that bonds have traditionally delivered: lower levels of volatility, a negative correlation to equities and a high degree of certainty in investment outcomes that comes from receiving predetermined coupons and principal at predetermined dates.

High-dividend stocks may deliver much-needed income, but can significantly add to the volatility of the portfolio. Consider General Electric Co., which was a high-dividend paying stock until it slashed its dividend last November amid balance-sheet problems. The stock fell 44% in 2017.

Market swings

REITs, which derive most of their income from real estate, have at times been good sources of income with stable characteristics, but the asset class was extremely challenged in 2008. The crisis was driven by a mispriced housing market and lax mortgage lending standards, and when that was corrected, REITs were hit hard, collectively losing 50% of their value in a 12-month period.

MLPs, which in the past have provided good income streams, have faced significant challenges over the last two years. Many MLPs derive their income from royalties on oil and gas production and transportation. But with energy prices so low and supply so high, there has been a tremendous degree of distress and numerous bankruptcies. Last year, the Alerian MLP Index, which measures the performance of MLPs, fell more than 13%.

As investors take on more risk, the correlation to equities rises considerably. While younger clients can withstand the potential volatility of riskier assets, for retirees or near-retirees, a sudden asset depreciation could be devastating.

Bond alternatives

When considering an alternative to bonds, advisers can seek investments that are engineered to act like bonds, to deliver income with higher certainty and lower volatility than equities.

Such engineered solutions may employ options, which have similar features to insurance contracts, as they make a payment on a future date that is contingent on an event taking place (the security being higher or lower than a specific price).

Consider an investment in a stock that has a long, consistent history of increasing dividends. It’s possible to add to the investment by purchasing a put option for protection against drawdowns in the stock. The premium for the put option can be covered by selling a call option that gives up extreme upside returns from the appreciation in the price of the stock.

The strategy costs about the same as the stock but lacks its extreme volatility. While investors may sacrifice some gains by capping the upside, they also protect the portfolio from volatility.

Engineered options

Engineered, options-based strategies can be accessed through products such as annuities and mutual funds.

Annuities can approach the safety and certainty of bonds. Insurance companies offer these products, with embedded optionalities in them, which they in turn hedge in the options markets. They aim to meet income needs with predictable returns and tax benefits for retirees, but they can be illiquid and expensive. Options-based mutual funds, meanwhile, offer daily liquidity and can be cost competitive compared to annuities.

Finding the income that bonds traditionally provided will continue to be a challenge as the year unfolds. But as advisers look to meet that challenge for their clients, they ought to be cautious about sacrificing low volatility and certainty for income.

Karan Sood is the CEO of Cboe Vest, an asset management subsidiary of Cboe Global Markets.