Alternatives Offer A Fixed-Income Substitute

One of the hallmarks of fixed income investing is its generally low volatility and steady return nature. Excluding areas of the market like emerging market bonds, distressed credit, and junk, the bulk of the bond market is pretty boring. Fixed income varieties like Treasuries, investment-grade corporate bonds, and munis are pretty bland. That boring nature comes from the fact that bonds pay a steady coupon rate semi-annually and then, when they mature, they pay their principal back. In the case of treasury bonds—and for much of the muni and corporate sector—this relationship is as good as gold.

But as the Fed raised rates, investors found out the hard way that this relationship isn’t always a easy path. The major bond benchmark, the Bloomberg US Aggregate Bond Index,as represented by the iShares Core US Aggregate Bond ETF (AGG), sank a whopping 13%. That’s the worst performance for the bond index since 1980. Globally, bonds did even worse, falling 31% for all 2022. Perhaps the even bigger insult is that one of the biggest tenets of bonds—its negative correlation to stocks—was broken.

For many investors, this decline and newfound correlation with riskier assets was a kick in the gut. Fixed income was always thought to be the safer choice when it comes to portfolio construction.

With bonds losing some of their stability and now offering a similar correlation to equities, many advisors and investors have been looking for answers. And one may come from institutional investors’ playbooks.

Retail investors and some financial advisors may not be familiar with strategies like market neutral, event driven or merger arbitrage, but your local pension or endowment managers do. All of them belong to a group of ‘asset classes’ dubbed liquid alternatives. Managed futures or long-short credit funds aren’t really their own asset classes, but are strategies. In that, they behave like their own thing.

According to BlackRock, alts perform many of the same duties that investors have traditionally used bonds for: ballast, low correlations during downturns, and income.

The beauty is that most liquid alts belong to so-called absolute return funds. That is, these strategies are designed to produce returns year in and year out. Now, those returns aren’t home runs but more like base hits. That consistency is why alts could make sense as bond replacements as a portfolio anchor. Most investors don’t buy individual bonds and hold them to maturity. As such, bond funds are subjected to pricing and interest rate risk. This is where alt funds have the advantage.

Secondly, since the correlation between asset classes has grown, bonds can no longer provide downside protection. However, alts are still one of the few non-correlated asset classes left. According to Goldman Sachs, liquid alternatives have a -0.1 correlation to investment-grade fixed income investments. This means they truly zig when the bond market zags. Moreover, since 1990, liquid alts have outperformed the S&P 500 between 13 and 47 percentage points during drawdown periods of 15% or more. This could provide the ballast niche that bonds once offered.

And finally, the beauty of these strategies is that they are often ‘gains’ and cash return driven. The nature of how these strategies actually create returns produces plenty of cash flows to investors. And depending on what strategies are employed can create higher than bond-like yields. Some of that might be tax-advantaged as well. For example, returns of capital distributions reduce the cost basis for investors and allow them to defer taxes.

Be sure to check our Alternatives section to browse through all available options.

Given the benefits of alts as a real fixed income replacement, investors may want to consider adding a slice to their portfolios. Many asset managers suggest that slice can be fairly big as well, citing up to 25% or more be alts. You may not need that much exposure to get some of the benefits. Some analysts have suggested a 10% weighting is enough to get the diversification benefits.

The easiest way to do it is through a so-called multi-alternative fund. These mutual funds or ETFs bet on a variety of strategies and sub-tactics to provide an all-in-one alternatives portfolio. They could be all you need to add exposure. As with any investment, kicking the tires and examining fees is key.

All in all, bonds may not be serving all investors’ needs in this day and age. But with the rise of liquid alts, there may be an answer to recapturing what’s missing from the bond market.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.