Structured Products and REITs

Recently we’ve been spending time looking at alternatives to bonds in our investment portfolios. Bonds put up a poor showing last year and lagged stocks considerably. It’s unfair to compare bonds to stocks since they’re not the same, and in fact are used to reduce portfolio risk because of this, but we’re drawn to make the comparison anyway.

Stocks rose 20+% last year while core bonds fell almost 2%. It’s reasonable to ask why we own bonds at all. But, as is often the case, we didn’t have to wait long for a real-world example of the market’s risk spectrum and the importance of bonds for more conservative portfolios.

As the stock market made its abrupt turn this year and speedily entered a technical correction last week, bonds generally held their ground, even in the face of expectations for at least a few interest rate increases by the Fed this year. Expected rate increases are a serious headwind for bonds, but investors still flocked to them when the stock market was at its most volatile. This so-called flight to quality is easily underappreciated when stocks are rising and speaks to owning a sufficient amount of high-quality bonds.

That said, you don’t have to hold only core bonds. As we discussed last week, you can add other flavors to juice up return potential within the fixed income side of your portfolio. But before you go exploring the wide world of bond alternatives, you should ensure you have your financial bases covered.

And by that I mean working backward to determine how much, if any, of your portfolio you can dedicate to alternatives. Here’s the rough framework I mentioned last week.

Cash in the bank = 1 – 2 years of spending (short-term emergency fund + known, or at least likely, big-ticket expenses).

Core bonds = 3 – 6 years of spending if you’re nearing or living in retirement. Maybe more, but I would only suggest less if retirement is more than, say, ten years off.

If you do the math you might find you don’t have much room for riskier types of fixed income investments. Or maybe you have a lot of room. In either case it’s important to think about these alternatives as not being a foundational part of your personal short- and medium-term liquidity; they’re longer-term compliments.

With that said let’s add to our list of alternatives. I’m not creating an exhaustive list by any means. There are tons of options and I’m mostly sticking with what’s typical and readily available in public markets. Going into private investments with no active secondary market, for example, adds complexity, cost, increases risk and generally gives me the willies, so I try to avoid it.

By the way, I’m not suggesting you run out and buy any of these. The list below should be taken as a jumping off point for your own research.

Structured Products – I’ll come right out and say that I don’t like these products very much, but they’re popular in certain circles so I want to mention them here. My experience with these products goes back to the Great Financial Crisis when many of them got hammered or went bust. These products are constantly being created and I’m sure many have done just fine since, maybe even surprisingly well. But the GFC illustrates the main issues with structured products: complexity and issuer risk.

Structured products are like a bond with bells and whistles attached to it. Investment banks like Goldman Sachs and Morgan Stanley “structure” these investments to hold your money for a couple to several years or more. Then they invest the money in a stock index fund or maybe even an individual stock like Tesla. If the investment rises over the period the bank pays you the gains, which are often capped at a certain maximum percentage. If the underlying investment value falls during the period you’d typically you’d get your money back without any interest. Often, however, if the index falls too much the contract stipulates that you’ll have the honor and privilege of sharing in the losses, either capped or shared fully.

These products can be extremely complicated, and that’s putting it lightly, especially when tied to options contracts, commodities, and foreign currencies. Additionally, while some products are FDIC-insured, most are backed solely by the issuer (the investment bank). And in my experience these and other risks are glossed over by the salespeople who schlep these products, so caveat emptor.

The bottom line is that there’s no risk-free way to get stock market returns. If you want exposure to a stock index or Tesla, for example, just keep it simple and buy those directly.

That said, there’s a secondary market for some structured products and volatility in the stock market can present buying opportunities. I have open access to these, and I reviewed several yesterday, but the minutia made me want to scream so I moved on.

Publicly-traded Real Estate

Real estate investment trusts (known as REITs) traded on a stock exchange are a more standard, and dare I say simpler, bond alternative. But they are not bonds, they are regulated trusts that trade like stocks. REITs can be made up of commercial or residential real estate, even mortgages. Part of their structure is to pass through most of the income they raise to investors in the form of dividends. This leads to higher cash flow than core bonds provide, which is obviously a huge bonus.

The problem, however, is that a REIT’s income and value are more subject to changes in the broader economy than a bond. The REIT could own shopping malls during a recession (or a pandemic) and see increased vacancy leading to declining rental income and lower payments to shareholders. Then maybe the value of the malls declines for the same reasons. All this and more impacts the REIT’s share price, at times making the category more volatile than the S&P 500, for example.

Because of the size of the REIT space, and the size variation among REITs themselves, I think it pays to be diversified. A good example of this is Vanguard’s REIT fund, ticker symbol VNQ. The fund owns about 170 separate REITs covering an array of industries and property types including healthcare, offices, retail, storage, and residential.

Diving deeper, an investor with conviction in a certain area could buy an individual REIT instead of (or in addition to) a fund. There are tons of options, but one worthy of consideration is Realty Income Corp, ticker symbol O. O is itself a diversified portfolio of around 11,000 properties with high occupancy, and good geographic and industry diversification. Interestingly, VNQ has owned shares of O within its portfolio for years, so buying one also gets you exposure to the other.

That’s it for this week. Next time we’ll round out our list by looking at convertible bonds, floating rate bonds, and fixed annuities.

Have questions? Ask me. I can help.

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