Your Life Simplified

Bond Alternatives: Investing in a Down Market

July 7, 2022

In this episode of Your Life Simplified, Mike MacKelvie, wealth advisor, and Valerie Escobar, senior wealth advisor, discuss bond alternatives and the pros and cons of bonds. Valerie and Michael talk about the basics of bonds, bond alternatives that you can invest in, rates of return and how impactful bonds can be in the market.

Transcript

Valerie Escobar: Hi, Michael MacKelvie, certified financial planner and cohost of “Your Life Simplified.”

Mike MacKelvie: How are you doing, Valerie?

Valerie: I’m good. I hear you do not live in a cave.

Mike: I don’t.

Valerie: Is that correct? That’s great. So, you’ve heard about the bonds that have been the news lately, about bonds.

Mike: Yeah. I feel like it’s just about everything right now. But yes, they’re still boring. But it seems like they suck now, too. So, it’s like everything bad.

Valerie: Everything bad is there, which coincidentally made me think about your girlfriends. You know, I hear… so, go with me on this.

Mike: Okay. I’m with you.

Valerie: I hear you’re dating a nice girl.

Mike: She’s great.

Valerie: Samantha. She’s good.

Mike: Yes. That’s her name.

Valerie: Samantha, last name, Old Bond. And Samantha, from what I hear, she’s a real steady, 10-year relationship kind of girl who works for the U.S. Treasury.

Mike: She’s got some stability, for sure.

Valerie: Perfect. So, nothing that’s too crazy or surprising.

Mike: Nope.

Valerie: That’s Samantha. But I heard that when you went to the gym the other day and in walked a new girl, Monique, Monique New Bond. And I can tell you remember Monique. What was it about Monique that was so interesting?

Mike: I hope Samantha’s not listening to this. I would say the unpredictability.

Valerie: Oh, okay. So, excitement.

Mike: Yeah.

Valerie: And that she’s got a really great interest rate, right?

Mike: Yes. Not that I would be interested in her, because I’m taken right now, and I have a girlfriend. She’s wonderful. But if I were.

Valerie: Higher interest rates are attractive, right?

Mike: Yes.

Valerie: And so that’s really what we’re talking about today. We are seeing a ton of volatility in the bond market, and it’s largely based on the fact that new, real sexy, interesting bonds are coming out with higher interest rates.

Mike: Yep.

Valerie: And they’re competing with the existing bonds that have a lower interest rate. And it’s just causing a lot of chaos, as we are seeing. And so, really what I wanted to do is let’s back up. Let’s look at how do bonds work. Bond 101, just give me the down and dirty on that, if you wouldn’t mind.

Mike: Yeah. Well, we talk about interest, and I actually have a question that has to do with relationships for you as well, if that’s okay. And I think a lot of people can relate to this, but have you ever met someone that you just couldn’t figure out?

Valerie: Oh, I think I married him, actually. Yeah.

Mike: So, maybe not the person that you married in this case, but there’s something that maybe, I think we can all relate to, maybe that one person that we maybe knew in our life from a relationship stance, that for whatever reason you knew maybe wasn’t great for you, but there was some…

Valerie: Okay. Yeah, that’s a different person, but yes.

Mike: … dopamine rush of unpredictability there. And I think there’s nothing quite like that. Even if it maybe isn’t what’s best for you. So, when we’re talking about bonds, there’s nothing exciting about predictability. There’s nothing exciting about that, okay? They’re literally trying to tell you from the get-go, “Here’s what you should expect.”

So, we think about how a bond works. You have a stated interest that you’re going to be getting from that bond. At the end of it, if you were to buy the individual bond, I know a lot of people buy bond funds now, but at the end of it, the maturity, as they call it, you would get your principle back.

So there’s nothing really exciting about predictability. And with all of these interest rate hikes that we’re having right now, Valerie, and the expected interest rate hikes, people are starting to wonder, “Okay, well, should I even be investing in these things? Because the whole reason why I did it was the stability. But is the return that I’m getting from this worth that stability, if it’s not giving me much of return?” And I think that’s the big question a lot of people have today, Valerie.

Valerie: Oh, absolutely. Going back to that initial example, that was completely fabricated, Samantha, I promise. When we have our 10-year bond that pays half a percent, let’s just say fictionally, it’s a hundred bucks for that thing.

Mike: Yeah.

Valerie: Well, we get a new bond that comes out and it’s a 10-year bond that is paying 3%. Well, guess what? Nobody wants to buy that original bond that’s paying half a percent at a hundred dollars. So that original bond’s dropping in price and the new bond, that’s where it’s at. And so, that’s where that weird inverse relationship with bonds come, the higher the prevailing interest rate, the lower the prices of the existing bonds come up. And so, it’s been such a long time since we’ve been able to actually live off of bond interest rates, maybe back in the ’80s you can say, “Yeah, my bond portfolio pays me enough that I can actually pay my rent and eat at the same time,” but we haven’t had that in such a long time.

And so, yeah, the unpredictability of shifting into what that is, my existing bonds are dropping and prices like crazy. Should I even be buying into new bonds because the interest rate’s going up, what if it continues to go up? What if there’s somebody else even more exciting than Monica or Monique or whoever it is, what do we do? And so that is absolutely the environment that we’re…

Mike: A new bond is formed.

Valerie: Yes, exactly. So that’s the environment that we’re trying to figure out right now. And so, some clients, and we’re hearing a lot of this, is they’re saying, “Forget it. I don’t want to even talk about bonds anymore. What else is there?”

Mike: Yeah.

Valerie: So, we got to address that. What else is there?

Mike: Yeah. I think understanding really why you even have a bond allocation is something that people skip over a lot of times, like what is the framework that exists there as to why somebody who’s retired, the 60/40 portfolio that we have, that floats around, why is it that there’s 40% in bonds? I think it’s important just to understand first, why that is before we get into the alternatives and really how it came to form. So 1952, a ways back, still there were some bonds out there, Harry Markowitz published “Modern Portfolio Theory.” He’s a Nobel Prize-winning economist. And really, what Modern Portfolio Theory said is we are going to create an efficient frontier, a formulaic weighting of portfolio assets to give people a framework for how they should invest. So, they should have about this much in bonds and about this much in stocks if they want to take on X amount of risk. So, depending on how much risk they want to take on, there was a weighting that was there, okay?

That’s still, I think, fairly present today, as far as how a lot of investors, investment representatives choose to invest people’s money. They follow this framework, this Modern Portfolio Theory. The problem is in 1952, was it more or less complex than it is today? The investment world, were there more or less options today, Valerie, in comparison to 1952? Obviously, there’s a lot more options today. Primarily in 1952, people were actually going and buying paper bonds, where they’d have the little coupon and they’d go to the bank, and that’s why they’re called coupon payments. They’d get their coupon, their interest back each month or every six months, depending on the bond. So, it was primarily just stocks and bonds. Today we have a much more intricate, complex investing world.

So the question is, okay, not only are there more investment options, but there’s also these other assumptions that don’t really seem to work out with Modern Portfolio Theory like the fact that it was almost entirely based on history up to 1952, and well, things have changed a little bit since 1952. Should I be considering any alternative? So that’s the framework as to why this is really questioned now like, “Hey, should I just have a 60/ 40 portfolio?” Modern Portfolio Theory, there’s some tests that it seems to fail. And because of that, people are saying, okay, maybe the 40% in my 60/40 portfolio isn’t just bonds, it’s other alternatives or other asset classes in addition to maybe 20% bonds or 30% bonds. And obviously, there’s not a direct recommendation here. So, I’m going to go through some of these alternatives, and Valerie, if you would, feel free to jump in on any of these or add any that might come to mind, because there’s an infinite amount here we could talk about.

But some of the popular bond alternatives that people seem to look to, I’d say one of the first is real estate. And it’s not that people in 1952 didn’t own real estate, it’s just there are new ways to invest in real estate that wasn’t really paramount back then. So real estate investment trust, for example, you can purchase securities, both private and nonprivate, however you want to go about this, that allow you to diversify across a number of different real estate holdings. And some people might look at that and say, “Okay, well, the return that’s coming from that is a lot better than my bonds. And there seems to be less standard deviation, less up and down than stocks, so maybe that’s a good bond alternative.” I think for any of these alternatives that we go through them, understand that I’m not saying it’s a one-to-one alternative or replacement for bonds, it’s the question of, okay, would a combination of these other assets make sense? That’s absolutely the case here with real estate.

It is not a one-to-one replacement for bonds because it has a lot more variance in its returns, a lot more standard deviation than bonds. Now, it has a lot more return, but again, the up and down is certainly quite a bit more than bonds. So, it’s not a direct replacement. And again, as I go through these, understand that the question is much more, “How do I combine these different risky assets to maybe form somewhat of a quasi-bond alternative package in addition to the bonds that I have?” So, I would say that’s one of the first ones, Valerie.

Valerie: Yeah. And I would add with that piece, too, is that, with bonds, people traditionally think of the income that they get paid. Those coupons, like you said there.

Mike: That’s a good point.

Valerie: And so, with real estate, if there’s rent, and that’s usually the case, then we’re also looking at another stream of income that can supplement or replace bonds. We’ll get to that thought a little bit later, too, but just something there.

Mike: Yeah. You’re exactly right. So, the higher yields, maybe yield… people thinking this is like a bond, because a lot of REITs have higher yields, but also they have income in the form if you hold it privately of just the rent that you’re collecting. So, it’s a great point. I would say preferred shares are another alternative people think of a lot of times. In a lot of ways, and people might not be fully aware of how preferred shares work, but in a lot of ways they are like a stock in a bond. You have higher yields, certainly less appreciation than, let’s say, growth stocks. But again, if we’re going to compare this directly to bonds, and this is the case for almost all of these alternatives, there’s more standard deviation. There’s more up and down with preferred shares than you would find with bonds, okay?

So, I don’t see this as a direct replacement, but it might be something that you combine into, again, if we’re breaking down the sleeves of your allocation, you have stocks, you have bonds and then you have this quasi-bond alternative, if you will, of the modern day, preferred shares might be something that you look at because you’re going to maybe get a little bit more interest, a little bit more stability than a growth stock, traditionally speaking. So, in comparison, historically speaking. So, I’d say preferred shares might be another option for somebody.

Valerie: Yep.

Mike: Another couple alternatives here. I won’t dive too much into this one specifically, but commodities seem to come up for a lot of people. The number one commodity that seems to come to mind is the shiniest, and that’s gold. And people look at gold as a bond alternative because of what it’s done in down markets or recessions. I actually created a video talking about just gold as a direct inflation hedge and how it fails that test as a direct inflation hedge. Again, I really look at this as its own asset class, very similar here, not a direct replacement to bonds, but something that can maybe generate some return. Now again, commodities is a broad range of assets, too. I think that’s important to note. You have gold, but you also have a lot other commodities that maybe haven’t performed to the point where you’d say, “Yeah, I just want to own a commodity fund.” If you actually look into what commodities have returned, you might not be as excited to invest, widely speaking, over a bunch of commodities and say, “Yeah, this is my bond alternative for the long haul,” but…

Valerie: And let me add, too, and I’m sure the podcast that you talked about with gold will dive really deep because that is such a broad conversation. But I think one of the most common piece points that is brought up is that bond is a physical, tangible thing like real estate, it brings comfort to people to have this thing. But when you start to really look into it, bonds themselves, there is no coupon, I’m sorry, gold.

Mike: Gold, yeah.

Valerie: Gold bullion cube, it’s not going to have a business model around it that’s going to yield anything. So it is something that I think on its surface is so shiny and attractive, but there is just so many different things to really evaluate.

Mike: The intrinsic value maybe isn’t there in the same form, whereas debt, you can understand, which the history of that is interesting of itself, but you can see a little bit more how debt is going to maybe help fund some venture for a company. And this is coming directly from a company. It’s not to say that, again, bonds don’t have their risk. It’s just that, yeah, that comparison is often made between the two, the intrinsic value, if you will. But another one that comes up, I would say, is infrastructure, especially with this massive infrastructure bill that came through. Infrastructure is a relatively new asset class, but where infrastructure really gained momentum, and this is unfortunate for a lot of investors, is after it did well. It seems to be the case a lot of times. So, bonds are dead right now, but maybe they won’t be so dead when these new interest rates that are coming out really start to kick up yields.

So theoretically in the long run, rising interest rates are actually better for bond funds because that means the new bond funds, the new bonds that are getting issued, you’ll have higher yields. You’re not typically buying bonds for their price appreciation. I don’t know anybody that’s really doing that, but we look at it right now we say, “Well, that’s down, plus I’m not getting much interest. Why would I ever do it?” And right now, we look at infrastructure and say, “Look at how great it’s done over the last year. Why would I not put a bunch of money into that?” Again, these correlations can change quite quickly. We got to make sure we come back to, okay, how does this all come together the most efficient way?

Infrastructure is an option, though. It does have, I think, some relatively considerable data that shows, hey, even in recessions there’s contracts that are put in place that are maybe government contracts that help hold it up a little bit more, and that might be attractive for somebody who’s seeking stability. But this is, again, just maybe one alternative you might have in this quasi-bond alt mixture of different assets.

Valerie: Yeah. And I think, too, just to speak to that understandable tangible piece, it’s got that, too, because you can say, toll roads can be something that will fit in that infrastructure. And so, you can think about, okay, people coming by and paying their tolls.

Mike: Yes.

Valerie: And another source of income stream that’s understandable. And so, I think I agree. I like that as a component as well.

Mike: Yeah. And when we think about, from an investment standpoint, government, and not all infrastructure is this way, but government infrastructure maybe seems a little bit more stability than some private investment, even though that sounds funny saying government has stability. I know people would maybe laugh at that, but from an investment standpoint, that has been the case. So, another just, I would say, alternative that’s out there is really the insurance realm. So, there’s two different asset classes there; there’s annuities and there’s life insurance. I’ll talk briefly through both.

These could both yield their full episode just in themselves, but annuities are a contract that you would get through some insurance company. And there’s typically some guarantee that comes with an annuity or at least some, let’s just say, hodgepodge guarantees, just different handful of guarantees that maybe come with annuity. That maybe yields a lot of people thinking, “Okay, this is a bond alternative. I can get some interest from an insurance company. They insure what I’ve given them and in return they give me income,” or if it’s a deferred, let’s just say a MIGO of sorts where you can continually roll over the capital gains going forward, some people might look at that as a bond alternative.

Again, not a direct one-to-one replacement here because, well, there’s some issues on the annuity side, typically liquidity, that’s not always the case. I fully understand that there are annuities that you can have some access or full access, but you’re typically giving up some form of return if you’re gaining that accessibility. The other side of annuities would be, as far as one of the downsides, when you’re seeking guarantees like this, you’re like bonds in a lot of ways, maybe not going to get the most exciting returns in the long haul.

It’s not to say they shouldn’t be considered, and it’s not to say that there’s not really a lot of different ways you can build these out, but those in large part, I would say, would be the considerations that come with annuities. I don’t know if you have any thoughts on annuities in life insurance. I was going to touch briefly on life insurance as well but it’s another one.

Valerie: Yeah, just that, like you said, you are paying… it’s insurance, it’s not free. You’re paying for insurance for that guarantee. And so, there is going to be always that trade-off there is with everything. There is no magic bullet. There’s lots of things that have a really fancy vineyard. And I think annuities are definitely one of them. Sadly, a lot of the interactions I have with annuities are new clients coming in, they’ve got into an annuity and they’re like, “Well, what on earth did I buy? Not what they wanted.” So, proceed with caution. They have their place, for sure. But I think it has to be really well understood and structured correctly.

Mike: Yeah. I would say like in the pecking order of sentiment that gets people excited, annuities probably fall below bonds. I don’t have people coming in fired up about their annuity. They maybe are this year so far given what’s happened. They probably feel pretty good about annuities. I know annuity sales are up in large part. Again, it tends to be the case that people go to these things when bad things are happening when the asset is doing well, which is actually counterintuitive in the long run of what you would want to do, but people tend to do that. The other type of insurance would just be permanent life insurance. This should not be viewed as an investment, first off, that should never be viewed as an investment, but as an investment-like quality in its cash value that maybe can make it appear like a bond alternative if you hold it for the long run.

Again, the issues here, you’re typically putting in a fair amount of money into a life insurance contract, and you’re not breaking even for a number of years. I know there’s different ways to structure this, to where you can break even earlier. But the trade-off is typically just rate of return, your expected return in the long run. If you’re doing this purely as a cash value play, which I hope that people maybe aren’t looking to…

Valerie: Quite a lot.

Mike: Yeah, in the beginning.

Valerie: Thank you.

Mike: But I know that there are plenty of insurance sales reps that maybe argue against that. That would be one of the first pieces I’d say, but some of the benefits here for high-income earners, the tax benefits, if you live in a high-tax state like California, for example, or Oregon, you get tax-free on the growth, a tax deferred as well if you take it in the form of a loan. Again, this should not be thought of as an investment first, but there are some tax benefits there.

The other couple ones I just want to touch on just in closing here, there’s some laddered option strategies. So, I know that we’ve actually used these, and they’ve certainly worked well here to begin this year, but you can think of it like buffering your returns, if you will. So maybe, you capture, and I’m speaking hypothetically here, you capture only 20% of the loss, and it’s capped out at that, or maybe you don’t capture any of the loss up to 10%, 15%. So, you’re buffered for that initial 10% to 15%, but then you can get appreciation up to 15% or 20%.

So, there’s some type of laddered strategy that maybe exists there. And again, I know we’re not in the business here of making product recommendations in a podcast, so I’m not going to speak specifically to any of them, but I’m just getting into hypothetically how it would be structured. I think you’re familiar with different strategies like that, Valerie.

Valerie: Yeah, absolutely. There are so many strategies like that. And I think one of the things to keep in mind, too, is the costs. The more complex it is, the more expensive it tends to be. There is quite a bit of volatility that could be involved. And there’s just so many different options. And I think that…

Mike: It’s a great point.

Valerie: … really does dovetail into the original discussion about bonds. Why are we even owning them? And are they dead? Is the intent of why bonds were created, is that time over?

Mike: Yeah.

Valerie: So, I wanted to talk a little bit on that. Did you have any other alternative things that you wanted to throw in right before I jump…

Mike: No, I would just say, in closing, as far as the alternatives, there’s plenty other ones, there’s structured notes, there’s different ways to do it, but it’s a question as always of just how does this all come together in the most efficient way for you?

Valerie: Yeah. And I think with bonds, we talk about, or what I like to remind clients is, what was the purpose? Why did we buy them in the first place? They do tend to have an inverse relationship with stocks. Of course, this year, as in the last 12 months, has been a total slap in the face like we got you, it definitely reacted exactly the same way. It’s not very common that we have both really high inflation and then a war with a global pandemic all happening at the same time. So, it is a tough environment, that’s for sure. But one of the things to remember, too, is that they do have less volatility than stocks.

Mike: Yeah.

Valerie: So, it can work as a hedge. There is income that is related to them, as when you look at it, the most simple way you can say, “I bought this thing for $100. I’m going to get it for 10 years. At the end of the 10 years, I’m going to get my $100 back. Even if the going price is $90, I still get my $100 if I let it mature.” Plus, I got to keep, clip my coupons all along the way. And so just…

Mike: That’s an individual bond, for sure.

Valerie: Yep. So just keeping those and really understanding if there is an individual bond portfolio, what that strategy is. And then also, one of the things to look at, too, is the demand on an existing bond. So, if everyone’s jumping ship and saying, “I don’t want any of the existing bonds, it only pays half a percent.” Well, let’s say that it has a 10% drop in the price. Someone else can say, “Well, I’m going to buy it and then I’ll let it mature. And so now I’ve recouped my 10%, plus I got my little bit of coupon along the way.”

So, there is going to still be activity going on. There’s going to be a return for bonds going forward. I don’t think the time is dead; if anything, if you have a portfolio that you don’t need the cash from, the long haul is still a very viable option. And then with buying new bonds, we will eventually get to it maybe, get to a point where people could actually, again, go back to living off of some of that interest and having it be something that’s actually worth buying into and saying, “Okay, I can get a reasonable return from this every six months” or whatever it is.

Mike: Yeah, there’s the expectations component, too. So, it’s expected that interest rates will go up. They’re going to keep raising interest rates. Sometimes people are like, “Well, bonds are going to keep just going down because interest rates are going up.” There is a priced expectation of interest rates going up into the bonds’ pricing. That’s why it’s dropped as much as it has. It wasn’t a huge shock when the Fed came out and said, “Yeah, we’re going to do 75 basis points. And that’s going to be our next raise,” the past week. That was priced into the market from a bond standpoint. And you can watch just days that the Fed announces this and see that it’s not the news of that rate increase that is swaying the bonds, because it’s typically priced into the expectation. So, if anything, it might be a great opportunity because that pricing has already taken effect and now new, higher-yielding bonds are coming into play.

So, I think in closing and just in short, if you’re at this stage where you’re now, “Okay, do I need other alternatives? Are there other options beyond bonds that really makes sense?,” it’s like you just pulled apart the kitchen and you got to do electrical work. You got to do plumbing. You need a freaking plasma cutter to cut the quartz countertops. You might need some help. You might not want to do all of that on your own because there is a lot to this. There is quite a bit to figuring out, “What do I want to compose of this alternative sleeve, what do I want to be full of,  what components?”

So, I think just in closing, if you’re at that point where you’re really considering these alternatives, it’s probably worth talking to someone, but understand that there is some serious legitimacy to owning different asset classes than just stocks and bonds as it relates to your portfolio.

So, hope you guys enjoyed this conversation today. Again, we wanted to touch on just different alternatives because bonds oddly are a pressing conversation for a lot of people. Not always, but typically when they’re not doing so well, this seems to come up.

Make sure to hit that ‘Subscribe’ button on YouTube, Spotify, Apple Podcasts, wherever it is that you’re listening, to get more content from industry professionals here at Mariner Wealth Advisors. My name’s Michael MacKelvie. I was joined again here by Valerie Escobar, certified financial planner at Mariner Wealth Advisors. You guys take care.

Valerie: Thanks, everyone.

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