Bond alternatives for income in a context of high inflation

Many physicians on the cusp of retirement worry about whether their portfolios will generate enough income now that inflation has hit a 30-year high.

Many physicians on the cusp of retirement worry about whether their portfolios will generate enough income now that inflation has hit a 30-year high.

Since many physicians are self-employed, they do not have a company pension indexed to inflation. Instead, they rely heavily on their accumulated wealth to fund their retirement, so having structured portfolios is essential to generate enough income.

The classic low-risk solution has always been bonds. This may have worked well for your father’s retirement portfolio, which likely used the classic and now obsolete 60/40 allocation of bonds to stocks.

But this allocation – or any allocation to bonds – has been meaningless for years due to falling bond interest rates. And now, with current inflation, bond investors are losing several percentage points per year instead of gaining several.

Now that bonds are a portfolio albatross, the challenge for retirees and near-retirees is: How do you ensure decent portfolio income in retirement with reasonable risk? What bond alternatives can generate enough income to stay ahead of inflation?

The surprising role of stocks

Some of the answers involve investing solutions that you might never have heard of, even if they aren’t really that esoteric. After all, they’re publicly traded and clearly visible to curious investors who bother to watch.

However, one solution is quite familiar and ironic: the stocks themselves. Stocks in general are widely dismissed as risky in times of inflation, but market history shows that the S&P 500 can provide an effective hedge against inflation. And within this index, dividend-paying stocks can be particularly beneficial as a long-term inflation hedge.

Of course, all stocks are subject to the ups and downs of the stock market, but reliable dividend payers known as dividend aristocrats – those with more than 25 years of dividend raising – tend to have good long-term results in performance and stability. They pay reliable dividends because they are usually large, mature companies. Unlike start-ups, they don’t need to invest a lot in research and development to achieve profitability; most of them have been profitable for decades.

Familiar Names

There are several dozen of these companies, many with familiar names including: McDonald’s, Colgate-Palmolive, Target, Walmart, Procter & Gamble, PepsiCo, Clorox, PPG Industries, Johnson & Johnson, and 3M. Many are currently categorized as value stocks, which could set the stage for a pickup in performance, according to some metrics. Many of these aristocrats are found in the holdings of exchange traded funds (ETFs) like Proshares S&P 500 Dividend Aristocrats (NOBL).

Buying and holding a diversified sub-portfolio of these stocks for the long term is a good way to position yourself for income with reasonable risk. During times of normal inflation, this stock class often beat bonds for net retirement income.

Less visible solutions

The other income producers are less well known. Since these are alternative investments (i.e. neither bonds nor stocks), they can add the necessary diversification to portfolios with high equity content. These investments include:

  • Real Estate Investment Trust (REIT). They are owner companies that own a wide range of rental properties, from billboards to office buildings to medical suites to apartments to marijuana greenhouses to cell phone towers and data centers. They have a special tax status which requires them to return 90% of their profits to investors in the form of dividends. REITs are generally not recommended for portfolio allocations above 10% or 15% for most individuals. But, since many of these companies were hit hard by the pandemic in 2020 and still have room to grow after increasing this fall, a larger portfolio allocation of carefully selected REITs might be a good tactic these days. . Many are paying dividends in the 4% or 5% territory, which should keep investors even with or above inflation in 2022, as inflation is expected to drop from recently released levels around 6% soon. . And if stocks go up, so much the better.

REITs tend to increase in value during times of inflation and rising interest rates, as landlords can increase rents accordingly; many leases include automatic indexation clauses linked to inflation rates.

Property values ​​tend to rise with prices in general, as the higher costs of labor, land and materials used in construction (all factors present) raise the bar for new development. This can restrict the supply of new rental properties, which means higher occupancy rates for existing properties, which drives demand and allows for rent increases.

REITs of all categories are available on the National Association of REITs website.

  • Variable Rate Preferred Share ETF (aka Variable Rate). Preferred stocks are the lesser-known half-siblings of common stocks (those simply called stocks). Something of a bond-stock hybrid, preferred stocks are bonds in the clothing of stocks. They often have less potential than common stocks, but also less decline or volatility.

Floating Rate Preferred Share ETFs hold stocks with dividend payments that fluctuate with market rates. This provides protection for investors during times of rising interest rates, an attractive feature now that rates appear likely to rise in the coming months. These funds now typically pay dividends of around 5% per year. With all preferred stock investing, active management is important because many passively managed ETFs track indexes populated by stocks that increase risk because of a characteristic known as negative return on purchase.

While Preferred Floating Rate ETFs are a useful portfolio tool, there aren’t many such products. Two examples are the Global X Preferred Floating Rate ETF (PFFV) and the Invesco Preferred Floating Rate ETF (VRP).

  • ETF based on options. These trade on the volatility of indices or defined share classes. Volatility is widely feared, but as a normal and expected characteristic of the stock market, it should be seen as something to be exploited for gain. “Risk is not the same as volatility,” said Warren Buffett, “but this lesson has only been taught in business schools, where volatility is almost universally used as an indicator of risk. pedagogical hypothesis facilitates teaching, it is totally wrong: volatility is far from being synonymous with risk. ”

Professional and advanced individual investors exploit volatility by trading options, betting on the rise or fall of a stock or group of stocks over a period of time. The complexity of options has long made them inaccessible to most individual investors. But in the last few years, around 120 option-based ETFs have appeared on the market, making options strategies widely accessible.

Some of these funds have seen double-digit price gains this year, with annual dividend yields well above 5% in many cases. And some use good coverage to potentially reduce risk. While these products make options strategies highly accessible to the average investor, a caveat applies: individual investors should take the time to assess risk, as even the use of option ETFs can be complicated. The investment can be coordinated with existing holdings. For example, if you own stocks in a Nasdaq 100 fund, you might want to offset the risk by hedging that stake with stocks, for example, of the Global X Nasdaq 100 Covered Call ETF (QYLD), which tracks the Nasdaq 100 but does not tend to rise as high because of the downside protection it offers.

While you probably won’t hear about these alternative investments on vacation cocktails, they could come in handy in your wallet. And lack of public awareness about them can reduce the risk of them being offered by your fellow cheerful creators.

Dave Sheaff Gilreath, a Certified Financial Planner, is a 40 year veteran in the financial services industry. He is a partner and chief investment officer of Sheaff Brock Investment Advisors LLC, a portfolio management company for individual investors, and Innovative Portfolios LLC, an institutional financial management company. Based in Indianapolis, the companies manage approximately $ 1.4 billion in assets nationwide.

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