An alternative source of income to bonds due to rising interest rates

Bond market uncertainty and unrelenting financial crisis for some investors increase in interest rates If it’s caused by inflation, geopolitical concerns, or other factors, that’s enough to throw in the towel, or at least significantly limit your exposure to bonds.

Many advisors and strategists say bonds should remain part of a diversified investment portfolio, but are shifting allocations to shorter-duration alternatives such as very short-term bonds. Some investors are looking for complementary non-bond products for investors who want to reduce their exposure to fixed income. “There are certainly a lot of alternative strategies that can generate current income for your portfolio,” said Tyler Glover, managing director of William Blair’s Private Wealth Management Consulting Services division.

These options include insurance-related securities, master limited partnerships, covered call ETFs, high-yield stocks, REITS, preferred stocks, asset-backed securities, and merger arbitrage.

Certainly, there are caveats when investing in these options. “If you’re trying to create an alternative source of income outside of bonds because of inflation risk or concerns about rising interest rates, there’s a trade-off between adding income from other sources and adding other risks to your portfolio,” said Matt Gentzkow, managing director at Coastal Bridge Advisors in Westport, Conn.

Gentzkow said it may be necessary to take more risks to produce higher yields or alternative sources of yield. Investors also need to be careful not to put too many eggs in one basket. He added: “You don’t need just one pool of income-producing assets that are exposed to a particular sector.” Additionally, some of the most popular income-oriented investments in the stock market are themselves sensitive to interest rates, which can undermine their investment case.

From one perspective, the higher the yield on a bond, the less compelling it is to adopt riskier alternatives based on yield alone. However, many major fixed income categories are suffering a tough period of negative performance due to rapidly rising interest rates, and investors are looking for income alternatives for reasons beyond yield alone.

With these caveats in mind, here are three broad categories with multiple investment options for investors seeking income outside of traditional bonds.

1. Stay within fixed income, but use non-traditional bonds

Insurance related securities

Paul Karger, co-founder and managing partner of TwinFocus Capital Partners in Boston, is a proponent of catastrophe bonds, also known as cat bonds. Cat bonds are high-yield, insurance-linked securities that allow insurance companies, reinsurance companies, and governments to transfer the risk of natural disasters to capital market investors.

Returns for this class are often in the mid to high single digits, but the past few years have been unusually strong, and performance is not directly tied to traditional financial markets. However, in years when the catastrophe rate is much higher than average and claims must be paid, returns can be negative.

Mr. Karger’s firm allocates 3% to 5% to cat bonds in nearly all of its portfolio through mutual funds. Artemis, for example, is primarily focused on this market, and its Victory Pioneer CAT Bond Fund (CBYYX) recently surpassed $2 billion in assets under management.

An example of an ETF in this space is the Brookmont Catastrophic Bond ETF (ILS). The total market return since the beginning of the year as of August 31st is 5.57%, but the ETF is characterized by a high net expense ratio of 1.58% as of June 30th.

2. Stocks that generate income

dividend stocks

Although high-dividend stocks are not a direct substitute for bonds, they do provide an opportunity for income through capital appreciation and dividend growth. The trade-off is higher volatility and market risk, and the need to avoid overweighting stocks.

Dividend ETFs generally have low costs, and there are many ETF choices. Capital Group Dividend Value ETF (CGDV), Fidelity High Dividend ETF (FDVV) and JPMorgan Dividend Leaders ETF (JDIV) will be one of the best companies for passive income in 2026, according to Morningstar.

real estate investment trust

While REITs can provide income and total return over the long term, they come with a “different risk profile than bonds,” Glover said. Real estate and bonds have traditionally been more volatile, as publicly traded REITS change prices all the time.

REITs allow investors to earn income through the collection of periodic dividends and the realization of capital gains from stock price appreciation. According to Morningstar, the top REIT ETFs include the Dimensional US Real Estate ETF (DFAR), Schwab US REIT ETF (SCHH) and SPDR Dow Jones Global Real Estate ETF (RWO).

Master Limited Partnership (MLP)

These are generally listed partnerships that invest in different parts of the energy sector, such as oil, gas, and transportation. Because MLPs distribute most of their cash flows to shareholders, these funds typically offer high dividend yields and tax-advantaged income.

Michael W. Crook, chief investment officer at Janney Montgomery Scott in Philadelphia, said many investors are attracted to high yields. This was especially true after the pandemic when interest rates were very low. However, in the current environment of rising interest rates, that is not a convincing argument for them. Crook isn’t too excited, given interest rate sensitivity and the fact that 10-year Treasuries are trading in the high 4% range. “The environment is very different from when the 10-year Treasury was paying interest at rates in the 1% range or lower in 2021.”

For investors interested in MLPs, there are several ETFs to choose from.

One option is the Global X MLP ETF (M.L.P.A.), invest in midstream pipelines and storage facilities that are less sensitive to energy prices. As of September 4, the 30-day SEC yield was 6.82%.

preferred stock

Preferred stocks provide a recurring expected return to your portfolio. These often rank higher than common stocks. However, preferred stocks are sensitive to interest rates, so investors should be careful not to overload their stock portfolios. These investments can be purchased as individual securities or funds.

You can choose from multiple ETFs. One option is the iShares Preferred & Income Securities ETF (PFF). As of July 31, the 30-day SEC yield was 6.52% and the expense ratio was 0.45%.

3. Alternative investment funds

merger arbitrage

Jeff Mortimer, founding partner and chief investment officer at Elyxium Wealth in Beverly Hills, California, focuses on income-oriented investments such as merger arbitrage ETFs and actively managed merger arbitrage funds.

Merger arbitrage exploits the price difference between merger announcement and merger completion, yielding returns that are uncorrelated with interest rate risk. According to Morningstar, this strategy produces a bond-like risk/return profile outside of the bond market, and notes that “like a bond coupon, upside is limited, but the potential for downside loss if the trade is abandoned is substantial.”

Merger Arbitrage ETF options include the NYLIM Merger Arbitrage ETF (MNA), the number of stocks held as of the end of June was 68, and the expense ratio was 0.77%. Another option is AltShares Merger Arbitrage ETF (ARB), held 62 stocks as of the end of June, expense ratio 0.76%, ProShares Merger ETF (MRGR), the number of stocks held as of the end of July was 41, and the expense ratio was 0.75%.

4. Alternative financing forms

asset backed securities

With upward pressure on bond yields, Stuart Katz, chief investment officer at San Francisco-based Robertson Stevens, is focusing on short-duration bonds and also looking for yield from outside bonds for risk and tax benefits.

One of the ways he accomplishes this is through alternative private market strategies. His company is looking for private business owners to lend against real assets such as rail cars, gas production wells and hard collateral. These investments tend to have shorter durations than typical investment grade bonds, often between one and three years. Broadly speaking, asset-backed lending opportunities arise with tax-deferred yields in the 6% to 10% range, Katz said.

Asset-backed securities are less sensitive to rising interest rates, so they may benefit in some cases. However, there is potential for liquidity risk and asset depreciation, which may raise concerns about collateral recovery.

One ETF option is the Janus Henderson Asset-Backed Securities ETF (JABS), we aim to generate income by actively allocating to opportunities across the U.S. consumer finance market. The net expense ratio is 0.33%.