Bond alternatives may not be the answer to low yields.
despite the number of articles I’ve written over the years that have a negative or warning tone, I am no Danny Downer. There’s no point in writing anything other than my candid opinion. Still, I reflected recently on my many negative articles, concluding that my often negative tone is a function of the proliferation of overpromises in our industry.
Perhaps the biggest overpromise today is that of bond substitutes. Bond yields remain skinny despite rising over the past year, which limits the return potential of balanced portfolios. In response, many investors and their financial advisors are opting to replace some or all of their bonds with other cash flow-generating investments. Dividend-paying stocks and real estate investment trusts (REITs) are popular choices for higher-yielding and higherreturning alternatives to bonds.
But these choices just give investors more stock market exposure and less diversification. And investors forget two things about these equities that spin off income: 1. When the stock market hits the next bear market, both dividend- payers and REITs will take it on the chin pretty hard, in line with the broader market. Income-paying equities lost more than the broader market in Canada during the global financial crisis. They also ended 2015 in a horrid, 16-month stretch that pushed prices down by 22%. Canadian stocks, in general, were down by only about 14% during the same time frame. The post-2000 tech bust is the only exception to dividend-payers’ deep bear market losses. 2. Many investors are under the mistaken impression that their dividend-payers will deliver them just as much in capital gains as the broader market — or more — on top of their dividends.
Suppose that stocks are going to deliver, for example, 8% a year in the future through a combination of dividends, which are paid and reinvested, and capital appreciation. That 8% figure is the total — not on top of dividends. And, like Warren Buffett’s Berkshire Hathaway Inc., if stocks paid no dividends, that 8% would be entirely in the form of share price increases. In other words, the dividend might be a signal of growth or cash-flow discipline, but it’s part of the total return.
On the other hand, unconstrained bond funds are bond funds in name, but have more subtle exposure to risky assets. One such popular fund boasts a high single-digit return this year. Its long list of positions not only includes asset-backed loan pools, private loans and emerging markets debt, but also a complex web of derivative positions. Some positions are straightforward, such as shorting bond futures to reduce duration. Others require digging to contextualize. Examples include long and short currency bets, reverse/repurchase agreements and long and short derivative positions (on credit and interest rates).
This fund offers meaningful exposure to i nvestment-grade bonds. However, a statistical analysis of its performance reveals that some 70% of its volatility is linked to global stocks and high-yield bonds, which, in turn, are factors that drive returns. Analysis also reveals strong correlation to global stocks and high-yield bonds.
If you want more stocks to juice returns, just add stock exposure with your eyes wide open. But let’s not toss bonds aside entirely. Bonds are meant to protect against equities’ bear markets and provide cash for rebalancing when stocks are at a low point. Loading up on too many bond substitutes will leave clients — and your book — more vulnerable in the next bear market.
Perhaps the biggest “overpromise” today is that of bond substitutes
Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.