The World Was Flat
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 general practice 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 similar, yet different answers. However, generally speaking, most will all suggest bonds or bond mutual funds be used in a portfolio as a hedge against stock market losses to reduce portfolio overall risk.
For many American investors, bonds have become synonymous with “safety” within a portfolio. Decades of indoctrination have created a common belief that holding bonds offsets risk of holding equities. Rather than questioning the popular belief, many today are going along with what they “know” to be true. ..But is it really true?
Before 1492 when Chris sailed the ocean blue, the world was believed to be flat. Saying otherwise would bring ridicule or worse. It was, at the time, an undeniable fact, and a fact you did not question. However, as we know now that perceived truth was a myth perpetuated by previous generations experience and perception about what was real and what was not.
For nearly three decades, bonds as a hedge against equity market risk made sense. The bond market like any other market is driven by supply and demand. When the stock market gets shaky, investors 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 the price of previously issued bonds with a higher yield up.
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 portfolio in bonds to hedge against stock market risk would balance things out.
While bonds have acted as a shield to defend a portfolio against equity market risk in the past they do have weaknesses. The weaknesses in the armor are interest rate risk and credit risk. The longer the duration of the 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, lower quality bond issuers will often pay a higher yield to incentivize investors to buy.
An Inverse Relationship
Markets evolve over time, and so do investment strategies. However, some truths never change. The inverse relationship between bonds and interest rates is as true today as it was 30 years ago. When interest rates fall, bond prices rise as they have for several decades. When interest rates rise, bond prices will fall.
Consider this, as interest rates rise, seemingly safe positions like bonds may end up hurting a portfolio rather than hedging against risk.
At the time this article was first penned the current yield on the 10-year note was below 2.5%. Investment-grade bonds were yielding between 2.5 and 4%. Higher yields could be found above 4.5%, but credit worthiness and risk of default increased with the yield. Today, the 10-year note is nearing 3%, and expected to continue to rise.
Thought bonds were safe? Think again.
As unemployment declines to low levels, more people are working and earning income. As real wages increase people have more money to spend. The new tax law’s lower income tax rates puts additional spending money in the pockets of millions of workers. Their increased supply of spendable money is now chasing goods and services whose supplies have yet to increase. Inflation is a likely threat. As a result of inflation, interest rates may be on the rise soon.
In fact, it was the threat of inflation and rising interest rates that was blamed by many for the mid February 2018 market correction. Think about that for a moment. Equities positions in your portfolio sold off, and your marketable securities investments lost money. At the same time, if you held bonds as a hedge against market risk, rising interest rates reduced the price of the bond allocation of your portfolio.
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%, our 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 rate of interest without the exposing a portfolio to the same credit or interest rate risk.
If you’re really using bonds in a portfolio to hedge against stock market volatility and risk of market loss, perhaps there are alternatives to add to your portfolio that will provide this hedge without the risk of reducing portfolio value as interest rates rise.
Index Linked Interest Credits
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.
There are Index Life products that exist offering potential to average interest credits of between 6% & 7% over an extended period of time. The cost of insurance and other internal charges are often causes for concern. After all, cost of insurance is the real drag on cash value accumulation. However, there are ways to reduce the cost of insurance.
In fact, it is possible to structure a policy in which 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.
Not all Index Life Insurance products are made equal. They are not all good, but they are not all bad either. Don’t throw the baby out with the bathwater.
Fixed indexed annuities (FIA) may also be appropriate as a bond alternative leveraged as a hedge against market risk. As with cash value life insurance, they are not all created equal. There are many index annuity products that offer little value to the policyholder; however, there are a few that offer significantly value.
Some products are designed primarily for income, and have very little accumulation potential. If purchased for accumulation, they would be very disappointing to the policyholder. However, there are a few products designed for accumulation. Costly features that drag down the accumulation potential have been removed. It is reasonable to assume they can earn an between 3 to 5% interest on average over a 7 – 10 year period without exposing your money to market risk, credit risk, or interest rate 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 an identified and agreed upon declining surrender charge. Avoiding products with a market value adjustment (also known as an interest adjustment), which can become ugly in rising interest-rate environment, is one way to reduce interest rate risk.
Truths Over Tradition
As an advisor, if I can reduce interest rate risk and credit risk for my clients why wouldn’t I? That seems like a good thing. If I could potentially replace a poor yielding portion of a client’s portfolio with ability to earn as much as, or more than the current yield on government treasuries and investment grade bonds, shouldn’t I consider it? It seems to make good sense. Unless I’m stuck in tradition, or my parent company doesn’t permit me the free will to use financial tools available to other independent advisors, would it be acting in my clients’ best interest to consider the facts and break from tradition?
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 you need income from your portfolio, and you’re content with the going interest rate on treasuries and investment grade corporate bonds, and intend to hold the bond to maturity, this may still be an appropriate position.
However, for the lowest performing assets within a portfolio, specifically those held as a hedge against stock market volatility and stock market based losses, index linked insurance products may be worth a look.
Holding bonds as traditional hedge against stock market volatility, a tried-and-true practice for decades, may have run its course. Consider looking at alternatives that provide protection from stock market losses, and an opportunity to potentially earn interest credits greater than yields currently found on government and investment grade bonds.