Once upon a time, investors looked to government bonds as the bedrock of a stable retirement income. Though bonds used to be the retirement investment of older investors, today, the idea of being paid while you sleep has become a major theme and aspiration for the Millennial Generation. Not to mention that bond yields are very low these days, making many investors seek bond alternatives.
This has sparked renewed interest in various investments that can generate a passive income. Exchange-traded funds (ETFs), for example, allow more access to various investment products. Previous products were far more complex or required far more capital than the average investor has available.
In this Guide:
Why Passive Income From the Market Is Under Threat
When someone talks about an investment portfolio, almost immediately, you probably think about stocks or bonds. In reality, there are many different types of investments for different goals and different risk tolerances. But sadly, traditional passive income from bonds is no longer as attractive as it once was. Here's why:
Government Bonds Yield Almost Nothing
One goal for many investors is income. This used to be achieved through a portfolio of bonds. Bonds pay a fixed yield at regular intervals plus your principal back at the end of the term.
Unfortunately for bond investors, government bonds these days yield almost nothing. And this means that the icon for investments that produce income has become useless in its original purpose. Even worse, with bond yields so low, any uptick in inflation means bond investors are guaranteed a loss.
Due to the all-time low in government bond yields, many people fled to corporate bonds. Though the yield there is higher, it's not enough to justify the added risk, especially in the high-yield category.
Dividend Stocks Yield More
The other method for income investing that has gained traction over the last decade as a response to low-interest rates is investing in dividend stocks. And the best of these could be the Dividend Aristocrats. These companies continually increase their dividends each year and have done so for years or even decades.
Dividend stocks seem to cover all the bases and can be bought using online stocks brokers like Ally Invest. You get a yield much higher than a bond might offer. Plus, you get the stock's capital appreciation, which was particularly good in the post-2008 bull market.
Double Whammy From COVID-19
However, as the saying goes, when something sounds too good to be true, it usually is. Most dividend stock investors felt this first hand when the market fell in March 2020. Many portfolios dropped 35% or more. And this caused many to panic sell. Worse, companies that had continually raised dividends for decades decided to cut their dividends for the first time.
This double whammy erased the reason to rely on dividend stocks for income. The companies that cut their dividends found their stock price plunging even further as millions who had invested in them solely for the yield sold out of their positions.
There Are Alternatives to Bonds and Dividend Stocks
Though maybe not as popular or well known as blue-chip stocks and index ETFs, there are investment vehicles that have existed for decades, whose main goal is to provide their investors with a steady income. Some of them are, in fact, older than ETFs.
These investments are freely traded on stock exchanges worldwide, with the majority trading in the United States. This availability gives investors two benefits: They are highly liquid and completely regulated.
The liquidity allows investors to buy and sell with ease, instantly, and without having to pay a massive spread between the buy and sell prices. And the regulations give investors peace of mind. Investors appreciate that these investment vehicles are regulated by the same laws and governing bodies as stocks and ETFs.
But what trait do these investments share that make them great for income?
Answer: They must, by law, pay out at least 90% of their earnings in the form of dividends to shareholders.
And what's in it for these companies?
Answer: There are tax perks for the managers of these investment structures. And the managers are often shareholders themselves.
In a nutshell, these investments have to keep paying out dividends, whether they want to or not.
As we are about to see, many of these investments are less correlated to the market. This provides investors with the additional benefit of real asset diversification in a portfolio — along with the income and capital gains.
Best 2022 Bond Alternatives
1. Real Estate Investment Trusts (REITs)
Real estate investment trusts (REITs) are the oldest and best-known bond alternative. This investment vehicle was created in the 1960s in order to provide regular investors a way to invest in funds that manage a portfolio of properties, which up to that point had been open only to accredited investors.
The REIT solves a major hurdle for regular investors:
- Most investors do not have the cash for multiple down payments nor the time to manage a portfolio of their own real estate properties.
- With a REIT, a professional manages a portfolio of hundreds of different properties. And investors get 90% of the profits.
- Another major benefit is that REITs diversify across hundreds of properties all over the United States or even the world. Rarely will an individual investor be able to adequately diversify his real estate portfolio in a short amount of time. This leaves him exposed to the risk of the value of a specific market plummeting. Hence, REITs.
- Investors can target specific real estate segments. The REIT space is huge. And it encompasses a lot of subsections such as commercial real estate, private real estate, and infrastructure. And some focus on just one specific geographic area. This means you can diversify over a number of properties in different geographies and even across different segments.
The great financial crash tarnished real estate's reputation. But real estate has been one of the most stable investments money can buy over the long term. REITs focus on income generation rather than speculative gains. Perhaps that is the main downside, as REIT investors cannot participate in house-flipping and other, more speculative real estate ventures.
Here are our recommended REIT services:
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2. Master Limited Partnerships (MLPs)
Though not as well-known as REITs, MLPs or Master Limited Partnerships have been in use since the early 1980s. An MLP is structured as a partnership between general partners and the limited partners.
The general partners manage the day-to-day operations. They usually hold a minority stake in the partnership. The investors provide the majority of the capital. Instead of being private, these partnerships are traded on an exchange. And instead of selling shares, an MLP sells “units.” Each unit entitles the investor to a share of the income the MLP produces.
One very famous name in the MLP industry is billionaire Carl Icahn. He houses around 50% of his own net worth in his publicly traded MLP, Icahn Enterprises.
The MLP structure may seem different from a REIT's, but the idea and principle is the same. The general partners enjoy special tax benefits as long as they distribute 90% of their income in the form of dividends.
Congress limits the use of MLPs to the capital-intensive industries of energy and natural resource sectors. Generally, MLPs raise capital for the nonvolatile yet essential support and logistics sectors of the energy industry. Examples include refining, storage, and pipeline construction.
MLPs generally do not focus on the more speculative exploration side of the energy industry. Instead, they focus on income generation. As such, investors get the diversification benefits of investing in the energy sector without the wild swings normally associated with those sectors. In fact, large oil companies commonly set up MLPs as a separate entity to handle their business's logistical and transport side.
Many MLPs offer yields far in excess of what can be found in the stock market. Many people invest in them as slow-growth yet stable income producers. The fact that energy, like real estate, outperforms during inflationary periods is also a handy bonus.
3. Business Development Companies (BDCs)
A few decades ago, Congress passed a law that created the business development company, or BDC, as an investment vehicle to spur economic growth in smaller businesses, whose growth as a whole had begun to stutter.
A BDC can invest in only small or medium-sized public and private businesses. And it must provide assistance to the business owner. Additionally, like the previous investment vehicles, BDCs must payout at least 90% of its earnings to shareholders.
In return, the managers of BDCs enjoy special tax advantages, can quickly raise large amounts of money from the public markets and are allowed to use leverage.
BDCs and Investors
This means that an investor can essentially buy into a private equity fund and enjoy a stream of high yield dividends. Just like the private equity industry, BDCs are highly uncorrelated to the broader market. However, due to their use of leverage and debt, they can be affected by rising interest rates.
BDCs also invest in distressed companies that need a turnaround. BDCs are subject to high volatility. So investors should see this as a more speculative investment with high risk and high reward.
Out With the Old; in With the New
Whether we like or not, we live in a zero-interest-rate world, the implications of which for the long term are not yet fully understood. But we know that investors who used to rely on bonds for their income have seen the market change and will have to change with it or be left behind.
Many market pundits believe that low-interest rates essentially force retirees, savers, and passive-income fans to invest in stocks, further pushing up their valuations. We have shown you that it is still possible to counter that effect and get an income from your investment portfolio. The diversification benefits these investments offer are worth a look.
As with all investments, these have risks and are seen as riskier than government bonds. Investors should also research the special tax nature of many of these vehicles and how it would affect them as an investor. And as always, when in doubt, consult a professional.