The nominees: potential investment grade bond alternatives?

Sources: Russell as of 12/31/14. Legend: ✓= meets criterion; blank = doesn’t meet criterion

Often, the first alternative offered up to replace bonds is cash and cash-like investments. After all, it has historically offered capital preservation and lower portfolio volatility. However, given the 0% – 0.25% target the Federal Reserve has set for short-term interest rates and assuming inflation remains above zero, the real return on cash and cash-like investments is negative. So cash is not likely a suitable replacement for bonds.

Admittedly, in the current low interest rate environment, bond yields are below their historical average as well. But even the modest yield on bonds has outpaced the negative real return on cash since 2008. That’s because the total return on a bond comes from two sources: price changes and coupon income. While true that bond prices go down when rates rise, coupon income remains intact (barring a default). So interest rate increases only affect one portion of a bond’s total return. In addition, bond returns have been historically derived mainly from coupon income and not price appreciation or loss.   This coupon payment has provided a cushion of stability that has also helped protect against losses.

Sources: Barclays Live. Coupon Income is defined as the annual coupon payments paid by the issuer relative to the bond’s par value.

High-yield bonds and higher-yielding securities

Another alternative some investors have recently been opting for as a replacement for their modestly yielding investment grade bonds are high yield bonds and higher yielding securities (e.g. REITs, MLPs or high dividend-paying equities). However, we would caution investors when reaching for yield . The trade-off for this incremental yield is a significant degradation of quality and an increase in the overall risk profile of a total portfolio. If capital preservation is important to investors, we’d caution using high-yield bonds and higher-yielding securities as an alternative to investment grade bonds.

Commodities

Others still have been looking to commodities as a potential alternative to their investment grade bonds. Commodities have historically had a correlation to equities somewhere between investment grade bonds and REITs . However, as with the previous bond alternatives discussed, commodities have not demonstrated a level of capital preservation or low volatility characteristics comparable to an investment grade bond portfolio. One has to look no further than calendar year 2014 when the Bloomberg Commodity Index had a total return of -17.0%.  That can be compared to the worst year the Barclays U.S. Aggregate Bond Index has experienced since its inception in 1976, of -2.9%. The historical lack of reliability of commodities’ capital preservation benefits also likely eliminate their suitability as a replacement for bonds.

Sources: U.S. Equity – Russell 3000® Index, High Dividend-Paying Equities S&P High Yield Dividend Aristcrts TR USD, Developed REITs – FTSE EPRA/NAREIT Developed Index, Global High Yield Bonds BofAML Global High Yield TR Hdg USD, Commodities – Bloomberg Commodity Index, MLPs Alerian MLP TR USD, Cash Barclays US Treasury Bill 1-3 Mon TR USD, Fixed Income – Barclays U.S. Aggregate Bond Index. Index performance is not indicative of the performance of any specific investment. Indexes are not managed and may not be invested in directly. Correlation is defined as a quantity between -1 and 1 that measures how two variables move in relation to each other.

The bottom line

In Russell’s view, investment grade bonds still have a role to play in a diversified investor’s portfolio – even in the face of potential rising interest rates. The asset classes many investors are considering replacing bonds with in their overall portfolio have historically failed to offer the same characteristics as investment grade bonds. Bear in mind, too, that there’s potential for increased equity market volatility in 2015. That’s precisely the sort of environment in which investors have historically benefited from a broadly diversified portfolio including equities, bonds and real assets .

No investment strategy can guarantee a profit or protect against a loss.

Indexes are unmanaged and cannot be invested in directly.

Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (junk) bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages. Investment in non-U.S. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries.

Exposure to the commodities markets may subject the investment to greater volatility than investments in traditional securities, particularly if the investments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or sectors affecting a particular industry or commodity and international economic, political and regulatory developments. The use of leveraged commodity-linked derivatives creates an opportunity for increased return, but also creates the possibility for a greater loss.

S&P High Yield Dividend Aristocrats Index: Companies in the S&P 500 who have increased their dividends for at least 25 consecutive years. The S&P 500 Dividend Aristocrats index tracks their performance, and is mainly comprised of large, well-known blue-chip companies. Standard & Poors will remove companies from the index if they fail to increase their dividends from the previous year. The index is updated annually in January.

Alerian MLP Index:  A composite of the 50 most prominent energy master limited partnerships calculated by Standard & Poors using a float-adjusted market capitalization methodology.

Barclays Capital 1-3 Month U.S. Treasury Bill Index: Includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. In addition, the securities must be denominated in U.S. dollars and must be fixed rate and non convertible.

Bloomberg Commodity Index Total Return: Composed of futures contracts on physical commodities. Unlike equities, which typically entitle the holder to a continuing stake in a corporation, commodity futures contracts normally specify a certain date for the delivery of the underlying physical commodity.

FTSE EPRA/NAREIT Developed Index is a global market capitalization weighted index composed of listed real estate securities in the North American, European and Asian real estate markets.

Barclays U.S. Aggregate Bond Index: with income reinvested, generally representative of intermediate-term government bonds, investment-grade corporate debt securities and mortgage-backed securities.

The Russell 3000® Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.

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