Bond alternatives for income amid high inflation

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

As many physicians are self-employed, they lack corporate pensions pegged to inflation. Instead, they rely largely on their accumulated wealth to fund retirement, so having portfolios structured to generate enough income is critical. 

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

But this allocation—or any allocation to bonds—hasn’t made sense for years because of withering bond interest rates. And now, with current inflation, bond investors are losing several percentage points annually instead of gaining several.

Now that bonds are a portfolio albatross, the challenge for the retired and nearly retired is: How to assure decent portfolio income during retirement with reasonable risk? What bond alternatives can deliver enough income to stay ahead of inflation?

Stocks’ surprising role

Some answers involve investment solutions that you may never have heard of, though they’re not really all that esoteric. After all, they’re traded in on public markets and plainly visible to inquiring investors who bother to look.

However, one solution is quite familiar—and ironic: stocks themselves. Stocks in general are widely dismissed as being risky in inflationary times, 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 advantageous as a hedge against inflation over the long term

Sure, all stocks are subject to the ups and downs of the equity market, but reliable dividend payers known as dividend aristocrats—those with 25-plus years of dividend increases--tend to have good long-term records of performance and stability. They pay reliable dividends because they tend to be large, mature companies. Unlike young companies, 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 such 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 may be mustering for a performance upswing, according to some indicators. Many of these aristocrats can be 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 long term is a good way to position for income with reasonable risk. During periods of normal inflation, this equity category has frequently actually beaten bonds for net retirement income.

Less visible solutions

Other income producers are less well known. As these are alternative investments (meaning, neither bonds nor stocks), they can add needed diversification to equity-heavy portfolios. These investments include:

• Real estate investment trusts (REITs). These are landlord companies that own a broad range of rental properties—from billboards to office buildings to medical suites to apartments to marijuana greenhouses to cell towers and data centers. They have a special tax status that requires them to pass along 90% of their profits to investors in the form of dividends. REITs aren’t usually recommended portfolio allocations upwards of 10 or 15% for most individuals. But, as many of these companies got beat up pretty badly by the pandemic in 2020 and still have room to grow after rising this fall, a more hefty portfolio allocation of judiciously selected REITs could be a good tactical move these days. Many pay dividends in the 4% or 5% territory, which should keep investors even with or above inflation in 2022, as inflation is expected to decline soon from recently published levels around 6%. And if shares increase in price, so much the better.

REITs tend to rise in value during times of inflation and rising interest rates because landlords can increase rents commensurately; many leases include automatic escalator clauses pegged to inflation rates.

Property values tend to rise with prices generally, as higher costs of labor, land, and materials used in construction (all present factors) raise the bar for new development. This can constrict the supply of new rental properties, meaning higher occupancy rates for existing properties, which pushes up demand and enables rent increases.

REITs in all categories can be found on the website of the National Association of REITs.

• ETFs of variable-rate preferred stocks (aka floating-rate). Preferred stocks are the lesser-known half-sibling of common stocks (the ones referred to simply as stocks). Something of a bond-stock hybrid, preferred shares are bonds in stocks’ clothing. They often have less upside than common stocks, but also less downside or volatility.

Variable-rate preferred-share ETFs own shares whose dividend payouts move up and down with market rates. This gives investors protection amid periods of rising interest rates, an attractive feature now that rates appear likely to increase in the coming months. These funds are now typically paying dividends of about 5% annually. With all preferred-share investments, active management is important because many passively managed ETFs track indexes populated by shares that increase risk from a feature known as negative yield-to-call. 

Though variable-rate preferred ETFs are a useful portfolio tool, there aren’t many of these products around. Two examples are Global X Variable Rate Preferred ETF (PFFV) and Invesco Variable Rate Preferred ETF (VRP).

• Options-based ETFs. These trade on the volatility of indexes or set categories of stocks. Volatility is widely feared, but as a normal, expected characteristic of the equity market, it should be approached as something to be harnessed for gain.“Risk is not the same as volatility,” said Warren Buffett, “but that lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: volatility is far from synonymous with risk.”

Professional and advanced individual investors harness volatility by trading options—bets on whether a stock or group of stocks will rise or fall within a set period. Options’ complexity has long made them inaccessible to most individual investors. But over the past few years, about 120 options-based ETFs have come on the market, making options strategies widely accessible.

Some of these funds have posted double-digit share-price gains this year, with annual dividend yields well upwards of 5% in many cases. And some use good hedging, to potentially reduce risk. Though these products make options strategies highly available to the average investor, caveat emptor applies: Individual investors should take time to evaluate risks, as even the use of options ETFs can be complicated. Investment can be coordinated with existing holdings. For example, if you own shares in a Nasdaq 100 fund, you might want to offset risk by hedging this holding with shares of, say, Global X Nasdaq 100 Covered Call ETF (QYLD), which tracks the Nasdaq 100 but doesn’t tend to rise as high because of the downside protection it provides.

Though you probably won’t hear about these alternative investments at holiday cocktail parties, they might be useful in your portfolio. And lack of public awareness of them can lessen the chance that they’ll be bid up by your fellow mirth-makers.

Dave Sheaff Gilreath, a certified financial planner, is a 40-year veteran of 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 money management firm. Based in Indianapolis, the firms manage about $1.4 billion in assets nationwide.