Bond Proxy, Explained
After the meltdown of financial markets that began in late 2007, the U.S. Treasury followed a low-interest rate policy to stimulate the economy. In this environment of ultra-low yields on the safest fixed-income investments, investors began to look to other higher-yielding investments. With little to no interest available on traditional safe havens such as bank accounts, savings bonds, or short-term U.S. Treasuries, investors who wanted to maintain their investment income felt compelled to take on more risk.
This added a new term to the financial lexicon: “bond proxies.”
The Meaning of "Bond Proxies"
So-called bond proxies are investment areas presumed to be enough to resemble bonds in terms of their ability to provide low-risk income, but with higher yields. Many financial advisors cautioned investors against this. Unfortunately, as investors learned in the second quarter of 2013, the financial advisors were right: bond proxies actually have quite a bit of short-term risk. The term "bond proxy" is a misnomer. A bond is a bond and there are no real substitutes.
The Lessons of a Down Market
In May 2013, investors were caught by surprise when U.S. Federal Reserve chairman Ben Bernanke suggested that the Fed may begin to taper its stimulative quantitative easing policy. The result was a sharp sell-off in the bond market, including the various types of higher-risk securities investors had purchased as bond proxies to boost their income.
In the period from May 21, 2013 (the day on which Bernanke first broached the topic of tapering) through June 20 (when the markets reached the lowest point of their downturn), investment-grade bonds fell approximately 2.8%. During that same time frame, income-oriented equity investments performed far worse, as gauged by the performance of some key ETFs:
- Dividend-paying stocks: iShares Select Dividend ETF (DVY), -6.1%
- Utility stocks: Select Sector SPDR-Utilities ETF (XLU), -9.4%
- Real Estate Investment Trusts (REITs): iShares U.S. Real Estate ETF (IYR), -15.7%
- Master Limited Partnerships (MLPs): Alerian MLP ETF (AMLP), -3.9%
- Preferred stocks: iShares U.S. Preferred Stock ETF (PFF), -5.0%
- Convertible bonds: SPDR Barclays Convertible Securities ETF (CWB), -5.1%
It’s important to keep in mind that this is just a one-month period, and it doesn’t reflect that fact that equities tend to provide superior returns to bonds over the long-term. At the same time, however, it serves as a clear example of the risks inherent in seeking higher yields outside of the bond market: when the times get tough, these investments can – and most likely will – lag bonds by a wide margin. This is acceptable for those with a long-term investing horizon and an understanding of the risks involved in allocating a portion of their assets to these riskier investments. But other investors, the events of May-June 2013 illustrate the dangers.
Do Not Be Fooled!
The lesson? Don’t be fooled by the concept that certain investments are “similar” to bonds. Unless an individual bond defaults, it will eventually return the full amount of principal to investors upon maturity.
And even bond funds, most of which don’t mature on a specific date, generally offer some limited downside unless they’re invested in a high-risk asset class. In contrast, even the conservative segments of the stock market offer no such guarantee. Alternative investments, among them oil and gas partnerships, real estate investment trusts, are volatile, offer no guarantees and may subject investors to unanticipated losses.
The bottom line: don’t take on investment risks -- including stock market investments -- labeled “bond proxies,” unless you can afford to withstand short-term losses.