5 Bond Alternatives That Deal With Inflation

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Intro

 

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Today we are going to discuss bonds. Bonds tend to suffer when there is high inflation, so it may not be a good time to purchase or add to them in your portfolio unless you plan to hold them to maturity.

Yet you need the steady income they can provide as part of your retirement plan.

Fortunately there are a number of income-producing alternatives to consider when investing your retirement savings.

We are going to look at five of those alternatives in this article:

  • FIAs
  • REITs
  • Preferred Stock
  • Dividend Stocks
  • Bond EFTs and Mutual Funds

Different Environment

It’s fair to say the past several years have been disruptive. One big area that we are all left dealing with is that of rising prices across the board. The fact is you have to go back 40+ years to experience a high inflationary period of this nature.

New Challenge

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For those already retired or approaching retirement, you know the importance of having a diversified mix of tools that will help you meet your goals and provide security in your golden years.

High inflation like we are currently experiencing presents a new challenge you might not have anticipated, especially when it comes to certain assets, such as bonds. Yet you know that bonds are often a major component when it comes creating the right allocation of products within your portfolio.

The good news is there are some alternatives that can be utilized in place of bonds that can address the income needs within your retirement portfolio.

Fixed Index Annuities (FIA)

There were well over $250 billion worth of annuities of different types purchased in 2021, yet for many people not familiar with them, as well as many in the financial media, “annuity” is considered a nasty word.

However, they can be a very useful tool – just like stocks, bonds, mutual funds, etc. – when used correctly in a well-constructed portfolio because they can address specific issues or goals, especially when it comes to retirement planning.

One of the primary differences between bonds and a fixed index annuity is that annuities are a form of financial contract between you and an insurance company. Your principal and many of the benefits built into the contract are guaranteed by the issuer.

A FIA is a type of fixed annuity. It provides principal protection and growth potential. They may also contain additional benefit options, such as lifetime income for you and your spouse.

In terms of the potential upside in your return, a FIA is benchmarked to an index, such as the S&P 500, allowing you to capture a portion of the positive growth in the markets in any given year. On the flip side, it’s not invested directly in the market, and has built-in protection against market losses in down years.

And a FIA comes with the added benefit of tax-deferred growth on gains, yet it is not subject to market risk like the stock market.

We have a good video for you to watch that compares FIAs and bonds. It addresses a groundbreaking study that demonstrates certain types of FIAs have outperformed bonds considerably over the last 25 years. Definitely worth a watch.

Important fact regarding annuitieshighly rated insurance companies are often viewed as being less risky than other financial companies because of the level of reserves they are required to maintain by regulators when compared to banks and other financial institutions.

REITs

There’s a good chance you’ve heard of real estate investment trusts or REITs at some point. There are a number of types of REITs and they are not all created equal in our opinion. REITs can be publicly traded or non-traded and are classified into three main types: equity REITs (own real estate), mortgage REITs (own mortgages) and hybrid REITs (own a combination of real estate and mortgages). We are referencing publicly traded equity REITs in this article.

Publicly traded equity REITS trade on an exchange, just like stocks and exchange-traded funds (ETFs), so they are generally considered liquid.

An equity REIT is operated or owned by a company whose focus is managing income-generating real estate, such as multi-family properties, corporate real estate, and similar properties. The rents from those types of property are what provide income.

The REIT is obligated to pay a large percentage of their taxable income to shareholders (at least 90%) in the form of dividends. Those dividends can make equity REITs a good alternative to bonds in a portfolio.

As with any type of investment there are downsides. Being comprised of real estate holdings, REITs often closely follow the overall real estate market. As such, they are subject to risks ranging from property value fluctuations and geographic demands to interest rates and occupancy changes.

One other major consideration is that compared to bonds, they are not generally considered a safe-haven investment due to their use of leverage and underlying real estate holdings.

Important Sidenote – We actually consider investment real estate (think a duplex, single family home or similar that pays you income) as part of our Core 4 framework for integrated retirement planning and investment management.

Preferred Stocks

Another type of security that can be a good alternative to bonds is preferred stocks. Just as with common stock, they typically trade on exchanges and are considered liquid.

But preferred stock is actually categorized as a different class than common stock and comes with a couple key differences.

First, shareholders of preferred stock have a preferential claim on dividends paid by a company versus the common stockholders of the same company. In fact, preferred stock usually comes with a set dividend that is often higher than that paid to common stockholders. As such, it is often characterized as a stock that acts like a bond.

Second, in the event of a bankruptcy, preferred shareholders receive liquidation funds before common stockholders of the same company if such proceeds come available. The same holds true for payments in the event of a corporate merger – preferred shareholders get their payments first.

One last comparison is that preferred stock, like bonds, are generally more stable than common stock. While there is upside capital appreciation potential, preferred stock tends to be less volatile and the potential for upside price growth is usually limited compared to common shares.

The potential downside to utilizing preferred stock as an alternative to bonds is that they trade in the equity markets, so you may be exposed to increased volatility and market risk. And they are subordinated to bonds in terms of payments in the event the company goes bankrupt and liquidates.

Dividend Stocks

Stocks that pay dividends can be another alternative to bonds because they share profits with their shareholders.

Dividend stocks are common shares, versus the aforementioned preferred stocks, and they are often issued by larger, more stable companies. These established companies consistently earn profits and distribute them to their shareholders in the form of dividends. While we don’t make specific recommendations regarding individual companies, some examples of current dividend paying stocks include AT&T, Dow, Duke Energy, Walmart and McDonald’s.

Investors are attracted to these companies due to their size, financial history, and ability to provide income through their dividends. And while many are not considered growth stocks (who typically reinvest their profits to help grow themselves) they still have the ability to provide upside returns in terms of price appreciation.

Just as with preferred stock and common stock, the potential downside to investing in dividend paying stocks is the market risk exposure that comes from trading in the equity markets.

Additionally, if things turn south for a company that typically pays a dividend, there’s no guarantee they won’t cut or even eliminate the dividend payment, which is one of the primary attractions for many investors.

Bond ETFs and Mutual Funds

No doubt you’ve heard of and are even invested in mutual funds. Whether you’re familiar with them or not, ETFs are similar to mutual funds, with a few specific differences.

Both are managed by fund managers, either passively or actively. Passive ETFs and mutual funds attempt to closely track a benchmark (ex. S&P 500), while actively traded funds attempt to outperform market benchmarks. For actively managed funds the managers identify opportunities they feel will enhance the holdings within the fund. With either passive or actively managed bond funds you don’t have to do the research like you would if investing in individual bonds on your own.

And given they are invested in a basket of bonds (differing types and maturities) you gain immediate diversification compared to purchasing individual bonds – eggs spread among different baskets versus highly consolidated in a single basket.

The potential downside is given these are managed portfolios you tend to pay management fees that can eat up a portion of your return.

Lessor Known Options

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If you look around you will probably see others suggesting CDs and High-Yield Savings Accounts as bond alternatives. Both come with limited returns so they aren’t necessarily good alternatives for bonds given they simply aren’t able to keep pace with inflation, especially in this current environment.

That said, brokered CDs can be an option. They tend to offer a higher rate than regular bank CDs. They are a bank issued CD and FDIC insured, but they are offered with a higher rate by a third party seeking to attract investors. They do trade in the secondary market so you can exit prior to maturity and without penalty, potentially earning you more. But they do come with market risk (traded on secondary market) and can lose value when selling before maturity.

Another product to consider is a Multi-Year Guaranteed Annuity (MYGA), which is another financial contract between you and an insurance company. You pay a premium and in return get a guaranteed fixed rate of return for a period that is set in the contract, usually three to 10 years. The benefit is guaranteed income and tax-deferred earnings until you take distribution.

Conclusion

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High inflation is a reality and may remain elevated for some time. This could

continue to negatively impact the bond markets going forward for some period of time.

Investors like yourself who would normally use bonds in their portfolios for various reasons will want to consider your options. This will mean seeking out viable alternatives that provide income and reduce risk in your portfolio.

Reviewing and making comparisons of the alternatives can get quite complicated. Given the importance of such a decision and its potential impact on your retirement plan, it makes sense to consult with a financial advisor or retirement planner.

We can help you in this process by explaining how each option works and answer your questions. This will empower you to make an informed decision.

We can even review your portfolio and help you optimize it to meet your future needs and goals so you have peace of mind during your retirement years.

If you’re ready to take the next step and talk to a team of retirement planners who put your interests first, Schedule a call today!

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