For virtually my entire career, bond yields have been characterized as "historically low" – yet have fallen with few interruptions. Since the financial crisis, however, yields have been super skinny and have continued falling. Razor-thin yields challenge traditional balanced portfolios. So many are dumping some or all of their bonds for higher-yielding and higher-returning investments.
But investors have been adding this extra yield (and total return) in exchange for increased exposure to stocks and treating them as bond replacements because of the associated income. Many have enjoyed the upside of this strategy but are likely unaware of the risk this involves.
When (not if) the next bear market occurs, don't expect these riskier bond replacements to offer any protection. Here are some popular investments or strategies that many have used as bond substitutes.
Dividend-paying stocks and REITs
The lure of equities paying a "steady stream of growing income" is understandable. Real estate investment trusts (REITs) and dividend-paying stocks offer attractive yields and the potential for rising payouts. But there are three problems with using them to replace bonds.
First, in bear markets, both dividend-paying stocks and REITs are likely to suffer as much as the broader stock market. They almost never protect against bear markets because they're likely to get swept up in the doom-and-gloom just like other stocks. See the accompanying table for some selected supporting statistics.
Second, while both dividend payers and REITs have outperformed broader markets over the past 20 years, the tailwind of falling interest rates has been a big factor. I expect that they'll perform fine in the face of rising rates but the extra return potential of the past is far from a sure thing in the future.
Third, investors assume that they'll be able to hold onto their income-producing equities better than other stocks because of the continued income flow. If dividends are paid in cash, price declines will be even steeper in bear markets than many realize. Take the S&P/TSX capped REIT index as an example.
The returns shown in the accompanying table are total returns – that is, they assume that all dividends are fully reinvested in the same index. And when dividends are not reinvested, the share price decline is more severe in bear markets. The table shows that the REIT index dropped by 51.5 per cent on a total return basis during the last bear market. But investors taking the dividends in cash would have seen the price drop by more than 62 per cent over two-plus years.
Think of watching your "capital" drop for two years, seeing every dollar invested drop to less than 38 cents. How do you know that it won't drop further? How do you stop yourself from selling out of fear that it will keep falling? The REIT index took more than four additional years for the price to climb back to its previous peak. That's more than six years under water. Admittedly this kind of decline doesn't happen often. But it will again at some point. And when it does, it will test all but the most disciplined investors.
Holding stocks and selling call options against those stocks – referred to as "covered calls" – is another strategy that some investors use to replace the income they once received from bonds.
But this is even worse than income-paying equities since the strategy offers more exposure to the market's down moves than it does when the market is leaping higher.
At least with REITs, you can enjoy the full upside of taking equity risk. With covered calls, you give away much of the upside while keeping the vast majority of the downside exposure. If you believe that markets continue to grow over time, covered calls are bound to underperform. There are better ways to hedge equity risk.
We build portfolios for clients using building blocks made up of exposure to stocks, bonds, cash and private market assets. Each building block has a defined purpose or role to play in pushing clients closer to their goals over time.
They offer clients a stable – albeit low – income stream. Bonds also offer stability since they tend to perform well when stocks fall hard. And that makes them a source of cash to rebalance when it's most important. So if you're looking for alternatives to your bonds, make sure your decisions are made in this kind of purpose-driven context.
Dan Hallett, CFA, CFP, is a principal with Oakville-Ont.-based HighView Financial Group.