Possible alternatives to bonds in your portfolio

While I feel all anticipated interest rate increases are already taken into account and therefore bond (and bond fund) prices already reflect expected future rate increases, many people feel bond interest rates will continue to increase, leading bond and bond fund prices to further decline.

With this in mind, many people may be seeking alternatives to bonds and bond funds. However, there frankly aren’t great alternatives.

It’s important to know how bonds fit into a portfolio and what purpose they have. Contrary to the widely held belief, bonds are not there to produce sizable amounts of income.

While the face amount of interest was much higher decades ago, so was inflation. When adjusted for inflation, the “real” buying power of interest wasn’t much better than it’s been in recent years.

So, if they’re not there to throw off copious amounts of income, what exactly IS the purpose of bonds and bond funds??? They are largely there to act as ballast of relative stability compared to the much more volatile and riskier stock portion of a portfolio.

Yes, the fact that bonds and bond funds throw off a little interest is definitely good. But the real value of them is to have some of your portfolio experience moves in prices that are much more muted than the moves in prices of stocks and other riskier assets.

With that said, if you’re afraid of the prices of bonds and bond funds decreasing if/when interest rates rise, what else can you use in place of bonds? Here are my thoughts:

Cash in banks. Cash is ultra-low risk in that there is no risk of losing any of your principal. However, the interest paid is jokingly small; currently about 0.50% to 0.60% for a high yield savings account, and not much better for a certificate of deposit (“CD”) that requires you to commit your money for a year or longer. Hence, keeping too much cash isn’t great option.
I Bonds. I Bonds are functionally savings accounts issued directly by the U.S. Treasury. The upside is they pay interest that’s based on current levels of inflation. At the moment, I Bonds are paying over 7% guaranteed interest. But if/when inflation subsides, so will the interest. Furthermore, you’re generally limited to buying only $10k per year, per person. Which means you can’t accumulate very much. Additionally, you can’t take out any money within the first twelve months of purchase.
Multi-Year Guaranteed Annuities (“MYGAs”). These are very similar to CDs in that you put money in, and in a few years you get it all back, plus interest. The difference is they’re issued by insurance companies. And the early surrender penalties are much steeper than those of CDs. The benefit of MYGAs is the interest rates are better than what banks pay; current about 2% for a two-year MYGA, and about 2.5% for a three-year MYGA. However, while guaranteed to not lose principal, those levels are interest are still not great, especially considering the inflexibility of the multi-year commitment.
Fixed Indexed Annuities. These products are quite complex, often have a five-to-10 year commitment periods and have other unique attributes that are quite different from bonds. A fixed indexed annuity could likely generate average annual interest of 2-4% over its life. As such, it could potentially be used as a replacement for some of the bonds in your portfolio. However, early surrender penalties could lead to a noticeable reduction in value if you don’t keep the contract for its full length.

As it can be seen, there is no perfect solution for the safe and stable portion of your portfolio; bonds and the other alternatives all have their own unique pros and cons. As such, the best approach may be to use bonds in conjunction with a few of the alternatives.