The next decade is very likely to be disappointing for a traditional 60/40 portfolio—in particular the “40” component. Almost all types of high quality/low-risk bonds are now yielding between 0.1-2.0%. If you buy and hold these bonds until maturity (assuming no defaults) you are accepting a very low nominal yield and will most likely experience a negative real return after any fees and inflation.
The benchmark bond in this space is the U.S. 10-year Treasury Note, which currently yields around 0.7% per year. This means if you buy a 10-year note today and hold it through maturity you would earn around 6.8% cumulatively in a full decade. It was only two years ago that you could buy the 10-year with a 3.2% yield, which equates to a 37% total return over a 10-year period. This difference in “risk-free” return is immense in terms of planning for investment returns, retirement, and income.
Other high-quality bonds including municipal (tax-free) bonds, investment grade corporate bonds, and TIPS, all of which also yield 2% or less. Cash and CDs offer no better option with yields between 0.1-1%.
So what should a long term investor who wants to contain overall risk but can’t accept a near 0% return on a large percent of the portfolio do? Our firm believes the answer is utilizing a spectrum of alternative/private investments that tend to have higher cash flows, low volatility, and low/no correlation to the stock market.
Below are some of the investments that our firm uses as bond replacements:
- Insurance-Linked Securities: Securities that offer long term equity-like returns with no correlation to the bond/stock markets or the overall economy. Their returns are tied to insurance premiums linked to earthquakes, hurricanes, winter storms, etc.
- Middle Market Lending: These are largely collateralized private loans to small and mid-sized companies. While the public corporate investment grade bond market yields around 2%, yields around 7-8% are common in this space.
- Alternative/Consumer Lending: These are small private loans made to consumers and small businesses across the country. The consumer loans are often used for higher rate credit card payoffs, home improvement, or special event borrowings. In one of the most prominent funds that invest in the space, the average credit rating of the underlying borrower is roughly 700. Yields here are in the 5-6% range.
- Real Estate Assets/Infrastructure: Holding a diversified portfolio of critical infrastructure (airports, pipelines, farmland, timberland, toll roads, utilities, etc.) can produce cash flows of around 3.5% and usually steady/predictable profits through an economic cycle, and inflation protection.
- Private Real Estate Credit & Equity: Private real estate (both on the equity and credit side) offers steadier returns, less leverage, and usually higher cash flows than their publicly traded counterparts. Yields on the real estate credit side can be as high as 10%, while 5% is attainable on the equity side.
- Private Municipal Bonds: These are similar to their publicly traded brethren in the sense that they are loans to support local governments or related entities across the country and offer tax-free income. Because these loans are privately negotiated they usually have no official rating and are illiquid, but they can sport yields of around 5% tax free.
The combination of the above alternative and private investments can create a “bond replacement” allocation that produces 3-5% in cash flow and offers competitive total returns over the long term. Of course, there are specific/unique risks and liquidity limitations to each one of these investments that the investor must understand. However, when combined in the aggregate, a lower volatility, high cash flow allocation that has little correlation to the stock market can be achieved.
This strategy if done with care, proper due diligence, liquidity planning, and position sizing can transform a portfolio and retirement plan.
The below graph shows a comparison of likely returns for traditional bond classes (current yields) and drawdown risk (assuming a 1% increase in rates in a 1-year period) vs. alternative/private investments.
Eric Mancini, CFA, CFP, CAIA is the director of investment research and a wealth advisor with Traphagen CPAs & Wealth Advisors (www.tfgllc.com). Traphagen is an independent fee-only fiduciary RIA located in northern NJ. He can be reached at email@example.com.