Definition and Example of Bond Substitutes
How do bond substitutes work?
Warning About Bond Substitutes
Definition and Example of Bond Substitutes
Bond substitutes are investment products (other than bonds) that mimic the performance of bonds while offering relatively higher returns. The term “bond substitute” is somewhat misleading – although some stocks share certain characteristics with fixed-income investments, it is not accurate to assume that anything other than a bond will behave like a bond.
How do bond substitutes work?
Bond substitutes typically gain popularity when interest rates are low and bonds provide negligible fixed income. When interest rates decrease, bonds offer lower fixed income to bond investors. After major downturns in the stock market, such as in 2007 or 2020, the income from bonds is often insufficient to keep up with inflation. This drives some investors to seek out bond substitutes to maintain high levels of fixed income while reducing their exposure to market downturns.
Example from a Bear Market
In May 2013, investors were surprised when then-chairman of the Federal Reserve, Ben Bernanke, suggested that the Fed might begin tapering its quantitative easing policy. The result was a sharp downturn, providing an opportunity to examine the performance of bond substitutes. From May 21, 2013 (the day Bernanke first mentioned tapering) to June 20 (when markets hit their lowest point in the decline), the iShares Core U.S. Aggregate Bond ETF (AGG) fell by about 2.8%. During the same period, investments in income-oriented stocks performed much worse, as evidenced by the performance of several major ETFs:
- Dividend-paying stocks: iShares Select Dividend ETF (DVY), -6.02%
- Utility stocks: Select Sector SPDR-Utilities ETF (XLU), -9.35%
- Real Estate Investment Trusts (REITs): iShares U.S. Real Estate ETF (IYR), -15.71%
- Master limited partnerships: Alerian MLP ETF (AMLP), -3.94%
- Preferred stocks: iShares U.S. Preferred Stock ETF (PFF), -5.53%
- Convertible bonds: SPDR Barclays Convertible Securities ETF (CWB), -5.34%
This data serves as a clear example of the short-term risks associated with seeking higher yields outside of the bond market. When times get tough, these investments can lag behind bonds.
Warning About Bond Substitutes
The term “bond substitute” may lead to the assumption that stocks are similar to bonds. In reality, bonds are fundamentally different from stocks. Unless an individual bond defaults, it will eventually return the full principal amount to investors if held to maturity. Even bond funds (most of which do not have a specific maturity date) generally offer some limited losses unless invested in a high-risk asset class. In contrast, even the most conservative stock categories do not provide such guarantees.
The takeaway is that you should not seek higher income levels from bond substitutes unless you can tolerate short-term losses. All stocks – even the safest ones – experience periods of volatility. There are no guarantees when it comes to investing in stocks. Investors holding stocks should always prepare for unexpected losses.
The Balance does not provide tax, investment, or financial services and does not offer advice. Information is presented without regard to the investment goals, risk tolerance, or financial circumstances of any specific investor and may not be suitable for all investors. Past performance is not indicative of future results. Investing involves risks including the risk of capital loss.
Source:
https://www.thebalancemoney.com/theres-no-such-thing-as-a-bond-proxy-416841
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