Volatility and risk are commonplace in the stock market. As you invest, you’ll find it’s best to mix your asset allocation between stocks and fixed-income assets. In general, a portion of your asset allocation will go to stocks and a portion will be allocated to bonds.
But should the safe-haven side of your portfolio be invested solely in bonds? What about diversification?
Fortunately, there are plenty of bond alternatives on the market today that will help in building a well-diversified, well-balanced portfolio.
The 7 Best Bond Alternatives for Your Investments in 2022
There are several reasons to look for alternatives to traditional bonds. In some cases, investors want to diversify their investment portfolios, and in others, the bond market simply isn’t performing well. Sometimes, retirees and other investors who live off their investments simply want to produce more income.
Here’s a list of some of the best alternative investments for the safe-haven allocation in your portfolio:
1. Certificates of Deposit (CDs)
Certificates of deposit (CDs) are certificates issued by banks in return for a deposit of cash. When opening a CD, you’ll receive a predetermined interest rate and make an agreement to keep the cash locked up in the CD for a predetermined period of time.
Unlike many bonds, CDs come with basically no credit risk, but there is a major drawback. CDs are illiquid, meaning they can’t be sold or transferred to another party. If you want to access your money before the CD’s maturity date, your bank will likely impose a stiff penalty.
The best time to invest in CDs is when interest rates are high. In doing so, you’ll lock in strong returns. However, when investing in a low-interest-rate environment, bonds and other alternatives will be your better bet.
Benefits of Choosing CDs Over Bonds
- No Credit Risk. CDs are FDIC insured, meaning even if the bank you invest in goes belly up, you’ll get your money back. Bonds are not insured in any way, exposing investors to credit risk.
- Potentially Higher Return. When interest rates are high, CDs are known to produce larger returns than some bonds.
- Low Minimum. Bonds generally require a minimum purchase of $1,000, whereas there are many CDs available with no minimum deposit.
Drawbacks of Choosing CDs Over Bonds
- Illiquidity. Once you buy a CD, you own it until maturity or pay a hefty fee to withdraw funds early. When you want to get out of a bond investment, you can sell it on the secondary market.
- Potentially Lower Return. When interest rates are low, CDs are likely to underperform bonds.
2. High-Yield Savings Accounts
High-yield savings accounts, primarily offered by online banks and investment brokers, offer returns similar to the bond yields you would expect on Treasury and municipal bonds, and they come with other perks.
Money in a savings account is held as cash, and there’s nothing more liquid in financial markets than cold, hard cash itself. As a result, liquidity is the name of the game in a savings account. With these accounts, investors don’t have to worry about credit risk either, since savings accounts are FDIC insured.
There is one major drawback to high-yield savings accounts, however. With bonds and some alternatives, you’re able to lock in strong returns when rates are high. That’s not the case with a savings account. When rates are reduced, these accounts automatically adjust the rates they pay to reflect current market conditions.
Benefits of Choosing High-Yield Savings Accounts Over Bonds
- No Credit Risk. Savings accounts come with FDIC insurance, meaning your money is insured even if the bank goes into bankruptcy.
- Liquidity. Cash is the most liquid asset in the world, and you’ll always have access to it when it’s in a savings account.
- Potentially High Returns. Returns on high-yield savings accounts have the potential to outpace those on short-term bonds; that’s especially true when interest rates are low.
Drawbacks of Choosing High-Yield Savings Accounts Over Bonds
- Potentially Low Returns. Depending on the term of the bond, returns on bonds will be better than savings accounts. If interest rates fall, a high-yield savings account’s interest rate may decline after you open your account.
- Fees. Some high-yield savings accounts will charge monthly fees that cut into your earnings.
- Minimums. Depending on the bank you open the account with, you may be required to maintain a minimum balance in your savings account at all times, which can become difficult when emergencies occur.
3. Real Estate Investment Trusts (REITs)
Real estate investment trusts (REITs) are an interesting asset class that gives investors ownership of a percentage of a portfolio of real estate investments. These trusts act like stock, but when you buy shares of a REIT, you’re investing in real estate instead of investing in companies.
The REIT collects money from a large group of investors to purchase and maintain a portfolio of real estate ranging from rental properties to cell towers to farmland. The profits earned from the properties are shared proportionally with the investors based on the number of shares they own.
Of course, some REITs are managed differently than others, and some perform better or worse. Therefore, when choosing one of these trusts, it’s important to do your research and pick one that has a strong history of performance.
Benefits of Choosing REITs Over Bonds
- Returns. REITs come with a significantly higher potential return than bonds. In fact, according to the National Association of Real Estate Investment Trusts (Nareit), REITs perform better than stocks on an annualized basis.
- Liquidity. Shares of publicly traded REITs can be bought and sold on the open market just like shares of stocks. Choosing a popular REIT will ensure your investment is liquid.
Drawbacks of Choosing REITs Over Bonds
- Risk. REIT investments come with the same risks as real estate investments. Retirees and other risk-averse investors looking for true safe-haven investments may want to consider other options.
- Liquidity. If you invest in an unpopular REIT, you may find it difficult to exit your position when you decide it’s time. Investments in private REITs not sold on major market exchanges may also be difficult to exit early.
4. Preferred Stocks
When you think of stock, you likely think of common stock. However, another option you have when investing in stock is buying preferred stock. Although preferred shareholders relinquish their voting rights, they receive other perks that make the investment worthwhile.
The vast majority of preferred shares come with a fixed dividend payment, making them fixed-income securities, and those dividends tend to be higher than dividends paid to common stockholders.
Those who hold preferred stock are also paid prior to common stockholders if the company fails and is liquidated, adding a layer of safety to the investment.
Benefits of Choosing Preferred Stock Over Bonds
- Higher Returns. Preferred stock has the potential to generate much higher returns than bonds if the investor is wise and makes well-researched investment decisions.
- Income & Value Appreciation. When investing in a solid company, buying preferred stock means you’ll enjoy fixed income and share in the price appreciation as the value of the company rises.
Drawbacks of Choosing Preferred Stock Over Bonds
- Volatility. Stockholders are exposed to stock market volatility whether they invest in common stock or preferred stock.
- Risk. Preferred stock comes with a higher level of risk than bonds. If the company were to be forced into liquidation, bondholders would be paid prior to stockholders, preferred or otherwise.
5. Dividend Stocks
Dividend stocks, particularly blue chip dividend stocks, are a great alternative to bonds for two reasons:
- The Companies They Represent. Blue chip companies are the largest and often the most stable companies in the world. So, although investing in them comes with some stock-related risks, those risks are relatively minimal.
- The Dividends They Pay. Blue chip companies are known for paying strong dividends to investors.
By investing in this particular category of dividend stocks, you’ll enjoy both stability and income. Moreover, these stocks tend to grow on a slow, steady upward trajectory, meaning you’ll likely enjoy price appreciation when investing in them as well.
Benefits of Choosing Dividend Stocks Over Bonds
- Reliable Income. Blue chip companies that pay dividends are known for providing reliable, predictable payments. As a result, you can count on a reliable source of income investing in stable dividend payers.
- Price Appreciation. Quality dividend stocks are known for slow and steady growth in value. As a shareholder, you’ll share in that price appreciation.
- Invest In What You Know. Blue chip dividend payers are some of the largest, most successful companies in the world. It’s highly likely you’ll know and maybe even do business with the companies you invest in.
Drawbacks of Choosing Dividend Stocks Over Bonds
- Risk. Whether you’re investing in blue chip companies or any other stock, when investing in stocks, you’ll be exposed to market risk. There’s also nothing preventing a company from cutting or suspending its dividend if its fortunes turn.
- Limited Income. In most cases, dividend income from stocks will be lower than income generated through fixed-income investments like bonds.
6. Fixed Annuities
Fixed annuities are an insurance product that provides investors with a fixed rate of return over a predetermined period of time. The idea of a fixed annuity is to provide reliable income well into your retirement.
Unfortunately, like other retirement-focused investments, if you withdraw your funds early, you’ll be required to pay steep penalties. Nonetheless, when held for the long-haul, fixed annuities will provide dependable income throughout your golden years.
Benefits of Choosing Fixed Annuities Over Bonds
- Set Income Amount. Fixed annuities provide a set amount of income for the lifetime of the investor upon reaching retirement. Bonds must be purchased and repurchased over time at prevailing interest rates to achieve a similar result.
Drawbacks of Choosing Fixed Annuities Over Bonds
- Liquidity. Fixed annuities are not liquid by any means. If you try to access your funds early, you’ll pay stiff financial penalties.
- Returns. Bonds typically offer a higher rate of return than fixed annuities.
7. Bond ETFs & Mutual Funds
Exchange-traded funds (ETFs) and mutual funds have become some of the most popular asset classes available today. These funds pool investing dollars from a large group of investors and use those funds according to their prospectus, paying investors their share of returns.
There are several providers of ETFs and mutual funds that focus specifically on bond investments. By investing in bond funds, you’ll end up with diversified exposure to the bond market without having to do the daunting research involved in choosing your own bonds.
Benefits of Choosing Bond ETFs & Mutual Funds Over Bonds
- Less Research. With ETFs and mutual funds, the bonds held in your portfolio are chosen by the fund manager, leaving the tough work to the experts.
- Safety Through Diversification. These funds tend to offer diversified exposure to a wide range of bonds in terms of types of bonds and maturities. This diversification further decreases your portfolio’s overall risk.
Drawbacks of Choosing Bond ETFs & Mutual Funds Over Bonds
- Passenger Seat. When investing in bond funds, you’ll be sitting in the passenger seat with your bond portfolio. The investment decisions will be made by the fund manager.
- Expenses. Bonds aren’t known as the investment that offers the highest return, and ETFs and mutual funds come with fees. These fees can cut into your bond allocation’s already modest returns.
Whether you’re not enthused with the bond market or you’re simply looking for a way to diversify your safe-haven allocation in your portfolio, there are several alternatives to choose from.
The key is considering the risks and rewards associated with each of your options and choosing the one that you believe will most effectively help you achieve your investment goals.