In the past, financial advisors have relied on a well-balanced portfolio of stocks and bonds to manage a client’s risk versus return. While the concept is widely accepted, if you ask 50 different financial advisors what a well-balanced portfolio of stocks and bonds looks like, you'll likely get 50 different answers. However, they will probably suggest bonds be used in a portfolio as a hedge against stock market losses to reduce portfolio overall risk.
Searching for Less Risk
This strategy made sense for decades. The bond market is often driven by supply and demand. When the stock market gets shaky, consumers flock to safety. Investors gobble up yield from seemingly safe positions like bonds. When this happens, the demand for bond yields increases relative to the available supply. This pushes yields on new issues down, which in turn, drives up the price of previously issued bonds with a higher yield.
Prevailing interest rates have been in a decline for decades. This relationship between stock market volatility and bond prices has been relatively reliable for the past 30 years. As a result, it would seem that having a portion of your client’s portfolio in bonds would help shield a portfolio.
While bonds have been a good shield to defend against market risk, they do have weaknesses. The biggest weaknesses are interest rate risk and credit risk. The longer the duration of bond, the higher the interest rate risk. The lower the credit worthiness of the bond issuer, the greater risk of default. To offset credit risk, issues will often pay a higher yield.
Consider this: As interest rates rise, seemingly safe positions like bonds may end up hurting a portfolio rather than hedging against risk.
Current yield on the 10 year note is below 2.5%. Investment-grade bonds are yielding between 2.5% and 4%. Higher yields may be found above 4.5%, but credit worthiness and risk of default increase with the yield.
It doesn't take much to drive bond prices down considering we've been stuck in a historically low interest-rate environment. The price of a 10-year coupon bond with a rate of 4%, yielding 4%, would be $1,000. However if interest rates rise and yields can be found at 5%, this bond’s value will drop nearly 8%. If yields could be found at 6%, the value of our bond could drop as much as 14%. It would seem like a lot of risk to take on for a rate of 4% when there are alternatives that may produce the same or higher rates of interest, without the exposing portfolios to the same risks.
Alternatives to Bonds
If you're primarily using bonds in a client's portfolio to hedge against stock market volatility and risk of market loss, perhaps there are bond alternatives to add to your clients' portfolios that will provide a shield without the risk of reducing the portfolio value as interest rates rise.
Consider this: a properly structured index universal life insurance (IUL) policy might make sense. Before you roll your eyes and hit the delete button, hear me out. The keywords are "properly structured."
IUL Costs Can Be Reduced
There are indexed life products that exist offering potential to average interest credits of between 6% and 7% over an extended period of time. The cost of insurance and other internal charges are often cause for concern with many advisors. Those charges are the real burden on cash value life insurance accumulation. However, there are ways to reduce the cost of insurance. It is possible to structure a policy in which the cost of insurance drops to zero within a few years after the policy is issued. Innovative companies even offer waiver of surrender provisions, providing for enhanced immediate liquidity.
Annuities Built for Accumulation
Fixed indexed annuities may also be appropriate as bond alternatives. Some indexed annuity products have very little accumulation potential. If purchased for accumulation, they would be very disappointing to the policy holder. However, there are a few products designed for accumulation by using a stripped down design. Costly features that drag down the accumulation potential are removed. It's reasonable to assume they can earn 3% to 5% over a 7 to 10 year period without exposing the policy holder to market risk.
Reducing Interest Rate and Credit Risk
When considering fixed indexed insurance products as a hedge against market risk, it is important to pay close attention to contract provisions. You may be able to mitigate or eliminate interest-rate risk in exchange for a known and declining surrender charge. Avoiding market value adjustment, which can become ugly in a rising interest rate environment, is one way to reduce interest rate risk.
As an advisor, if I can reduce interest rate risk and credit risk by replacing a poor yielding portion of a portfolio with a contract issued by a financially stable company, giving my client the ability to earn as much or more as the current yield on government treasuries and investment grade bonds, why wouldn't I consider it?
Finding the Best Balance for Your Clients
Leveraging properly structured, indexed cash value life insurance, and accumulation-focused index annuities may not be the right substitute for replacing all of the portfolio’s bond holdings. As an income portion of an overall portfolio, bonds can still make sense. If your client needs income, and they're content with the going interest rate on treasuries and investment grade corporate bonds, and they intend to hold the bond to maturity, they may still be an appropriate addition to their portfolio. Even if that income is earmarked to purchase additional bonds at potentially higher future rates of return at a later time, as with bond laddering, it still might make sense. However, for the lowest performing assets within a portfolio, specifically those held as a hedge against stock market volatility and stock market losses, they may be worth a look.
Holding bonds as a traditional hedge against stock market volatility, a tried-and-true practice for decades, may have run its course. Consider looking at bond alternatives that provide protection from stock market losses, and an opportunity to earn interest greater than yields currently found on government and investment grade bonds.
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