- A search for yield has led to greater popularity of alternative approaches in investing in bonds.
- But non-traditional bonds may be less popular among financial advisors due to lack of awareness, lack of promotion and the amount of research needed to employ them successfully.
- Products attracting interest include so-called green bonds, foreign currency-denominated bonds in emerging markets and state municipal bonds using tobacco settlement monies.
As renewed interest in bonds continues, there is also growing interest in non-traditional bonds and strategies.
"The financial crisis of '07 to '09 resulted in much lower interest rates, which led to new and different investment mandates in bond investing," said certified financial planner and CPA Edward P. Schmitzer, president and founder of River Capital Advisors.
The resulting search for yield led to greater popularity of alternative approaches in investing in bonds. Yet they may be less popular among financial advisors due to lack of awareness, lack of promotion and the amount of research needed to employ them successfully, he said.
Schmitzer works with different types of bond fund managers, including:
- Flexible fixed-income mutual fund managers not bound by a mandate to buy only certain types of bonds. These managers have a wide investment mandate, allowing them to invest in a mix of Treasurys, corporate bonds, TIPs, high-yield bonds, etc.
- Bottom-up corporate bond mutual fund managers, who look for the best price with the best return potential, regardless of type. "We like [using them] as yields are better," he said. "Risk is also higher, and we value bond managers that analyze and invest in individual bond securities based on their analysis and valuation discipline."
- Dedicated floating-rate bond fund managers. "We are using them for more conservative portfolios," Schmitzer said. "There is company risk, but the interest-rate risk is negated with these bonds."
In addition to non-traditional strategies, Schmitzer is working with emerging market local currency bonds. While these investment-grade sovereign bonds are part of a volatile asset class and currency impact can be material, he said, he sees them as a part of a well-diversified fixed-income allocation.
"We like the non-dollar denomination, which provides currency diversification," Schmitzer said. "Although we cannot predict where currencies go, we do believe the dollar is at a high level, goes in cycles, and with a decline we will get a return increase.
"Also, the yields are in the 6 percent range while we wait."
Eric Mancini, CFP, director of investment research and wealth advisor with the Traphagen Financial Group, also uses emerging market bonds in the form of investment-grade corporate bonds. These are often from places such as China, India and Thailand and may yield 4.5 percent to 5 percent.
He also makes use of other non-traditional bonds, such as:
- Catastrophe bonds, issued by U.S. or international governments, the United Nations, reinsurance or other types of companies to cover insurable extreme natural disasters, such as earthquakes, fires, hurricanes, etc. Interest rates can range from 4 percent to 6 percent.
- Peer-to-peer loans, a type of alternative lending arrangement for individuals and small businesses. Seeing yields of 5 percent to 6 percent, these loans are considered by Mancini as low volatility and not impacted by international rates.
"A combination of these specialized bonds doesn't increase risk," Mancini said. "We've found them to be a great replacement for traditional bonds because they provide potentially higher return and because traditional bonds are at such a low bar."
He has noticed an increase in availability and awareness of non-traditional bonds in recent years, especially among registered investment advisors.
For his part Peter McAleer, founder of McAleer Wealth Management Group, has found a niche in using municipal bonds issued by states based on the 1998 Tobacco Master Settlement Agreement between the four largest U.S. tobacco manufacturers and 46 states. The states receive cash flows every year and earmark this money to back municipal bonds with a guaranteed 3 percent return or higher, depending on inflation.
Investor perceptions of these bonds can be off, McAleer said. "Many people don't understand or appreciate their value and might avoid them because of their concerns about tobacco use, or they may feel guilt by association," he said. "But actually, you're not supporting tobacco.
"These are municipal bonds backed by the settlement from a massive class-action lawsuit."
Looking to support environmental and social change in a proactive way, Shane Yonston, CFP, principal advisor with Impact Investors, works with so-called green bonds or climate bonds that are linked to environmental projects. These municipal bonds are issued to address activities such as land conservation, environmental cleanups and renewable energy and provide tax-free returns along with a social impact.
Yonston uses these for income ladders for more conservative portfolios. "They are for a targeted impact with tax-efficient income," he said. "It's a stable asset — much more stable than corporate bonds, and you're helping a city do more environmental projects."