The time to look beyond bonds for income is right now

While most clients might initially find themselves in front of a financial adviser because of a focus on investment performance as measured against something like the S&P 500, the more immediate value add from any adviser who is paying attention tilts more toward the boring old fixed-income side of the portfolio.

In an environment where the Federal Reserve has committed to keeping rates low for longer out of a responsibility for the larger economic picture, any investor seeking the benefits traditionally found in a standard bond allocation is left treading water, at best.

For advisers, it all boils down to reconciling the original purpose of a bond allocation with the current reality that effectively strips away the income component relative to even modest inflation.

Purists will argue that bond allocations in some variation of a 40% weighting, are there as portfolio shock absorbers first and foremost and that income is a welcome bonus.

While the benefits of ballast when it comes to bonds is difficult to dispute most of the time, there are always exceptions.

This past March, for example, when the stock market lost 30% in less than four weeks as the weight of the pandemic sunk in, the investment-grade corporate bond market followed suit as the market questioned the ability of companies to repay their debts.

“March was a great example of why you don’t want to take credit risk,” said Jeffrey Nauta, principal at Henrickson Nauta Wealth Advisors. “You’ve got to be aware of the correlation of your bond holdings.”

The fact that the Fed stepped in to sort of right the ship with an unprecedented purchase of corporate debt should provide less, not more, solace to fixed-income investors because it further underscores the fragile nature of the bond universe for as far out as most analysts care to look.

Even legendary economist and investing guru Burton Malkiel is waving a warning flag regarding fixed income.

Malkiel, perhaps best known as the author of the classic finance book, "A Random Walk Down Wall Street", is the chief investment officer of WealthFront, and he has recently been advising against traditional bond allocations.

“My feeling is that a 60/40 allocation is wrong today, but it’s not going to be wrong forever,” he said.

Citing “an era where central banks all over the world have pushed interest rates to close to zero in the U.S. or negative” in part of Europe and Asia, Malkiel said, “even if inflation stays moderate at just 2%, fixed income is a losing strategy, and the bond market has basically been rigged by central banks to have yields that are not going to provide adequate income for retirees.”

In underscoring that he recommends allocating “very little to bonds,” Malkiel joins a raft of other forward thinkers in getting creative when it comes to income.

“What I have been advocating for is a surrogate bond portfolio that would consist of some blue-chip high-dividend-paying stocks,” he added. “I think there will be much less risk there, rather than buying a bond portfolio that’s a sure loser.”

FINDING ALTERNATIVES

For Nauta, who is trimming standard 40% bond allocations down to 20% or less, the income portion is being spread across a blend of fixed-income alternatives, including real estate and real assets like timberland, farmland and infrastructure.

He’s even allocating clients to portfolios of life settlements, which involves taking over the premiums of whole-life insurance policies.

Nauta is also buying brokered certificates of deposit, which are paying yields about 25 basis points above Treasury bonds.

The tradeoff for the income boost over traditional bond funds is often less liquidity, but Nauta recognizes that as the price of admission and he doesn’t see it as a problem.

“We’re not getting 6% when the market is at 1% to 3% for fixed without taking some liquidity risk,” he said. “We’re looking at maybe quarterly liquidity and in periods of stress, people might not be able to fully redeem initially. But even for people in retirement, having somewhere in the neighborhood of 20% in less liquid strategies can absolutely make sense.”

Daniel Graff, principal at Sullivan Bruyette Speros & Blayney, sees the fixed-income challenge as a moving target that requires more flexibility than ever.

For income alternatives, at the moment, “the obvious answer is stocks, and if income is what people are searching for, the S&P yield is close to 1.7%, compared to 10-year Treasury at less than 70 basis points,” he said. “If you’re looking five to 10 years into future a bond portfolio is a guaranteed negative return.”

From Graff’s perspective, any client with a longer time horizon who can stomach the volatility, he recommends stocks over bonds.

And for everyone else, he will sprinkle in some real estate or a hedging strategy to smooth the ride.

“In some ways it’s boring to talk about a hedge fund yielding 3% or 5%, but that can be really compelling for someone just looking for some income in a low yield environment,” Graff said. “If we don’t solve this problem in the U.S., you can see risks of continued dollar weakness and maybe you can see a place for precious metals. You can protect a portfolio in more ways than just using bonds.”