Price Stability
In theory, bond proxies have stronger price stability than other stocks. If the stock market falls broadly, bond proxies may experience less of a price decline—similar to how bonds perform during these same events.
Income
The other aspect of bonds that bond proxies seek to replicate is the promise of a fixed income. Bond proxies have hefty dividends that are meant to rival the interest or coupon payments from bonds. Dividends are often cash payments made to shareholders by a company as a reward for investing in the company’s stock. However, the term “bond proxy” is a bit of a misnomer, since some stocks share characteristics with fixed-income investments; they don’t always act like bonds.
Example
Investors seeking stable income during a recession and down stock market might invest in stocks in the utilities sector. Utilities often enjoy natural monopolies, and basics like internet service and electricity are among the last costs a family will cut to save money. As a result, utility stocks can provide more stability to an investment portfolio and usually pay attractive dividends. Utility stocks tend to hold up in bear markets versus other stocks because they are not usually sold off as much as equities tied to economic growth.
How Does a Bond Proxy Work?
The popularity of bond proxies usually rises during low-interest rate environments. When interest rates fall, bonds offer less fixed income for bond investors. After major stock downturns, such as in 2007 or 2020, bond income hardly keeps up with inflation. This drives some investors to look for bond proxies to maintain high levels of fixed income while minimizing their exposure to market downturns. Another example of bond proxies are real estate investment trusts (REITs), which are firms that own and operate real estate. REITs pay the majority of their profits to their shareholders as dividends. Periods of economic distress typically spare these investments—at least compared to other stocks. Real estate contracts are typically long-term, so short-term declines in stocks can have less of an effect on REITs.
An Example From a Down Market
In May 2013, investors were caught by surprise when the then-chairman of the Federal Reserve, Ben Bernanke, suggested that the Fed may begin to taper its stimulative quantitative easing policy. The result was a sharp sell-off, which offers an opportunity to study the performance of bond proxies. In the period from May 21, 2013 (the day on which Bernanke first broached the topic of tapering) through June 20 (when the markets reached the lowest point of their downturn), the iShares Core U.S. Aggregate Bond ETF (AGG) fell by roughly 2.8%. During that same time, income-oriented equity investments performed far worse, as gauged by the performance of some key ETFs:
Dividend-paying stocks: The iShares Select Dividend ETF (DVY), -6.02%Utility stocks: The Select Sector SPDR-Utilities ETF (XLU), -9.35%Real Estate Investment Trusts (REITs): The iShares U.S. Real Estate ETF (IYR), -15.71%Master Limited Partnerships (MLPs): The Alerian MLP ETF (AMLP), -3.94%Preferred stocks: The iShares U.S. Preferred Stock ETF (PFF), -5.53%Convertible bonds: The SPDR Barclays Convertible Securities ETF (CWB), -5.34%
This data serves as a clear example of the short-term risks inherent in seeking higher yields outside of the bond market. When the times get tough, these investments can lag behind bonds.
A Warning About Bond Proxies
The term “bond proxy” can lead to the misconception that a stock is like a bond. In reality, bonds are fundamentally different from stocks. Unless an individual bond defaults, it will eventually return the full amount of principal to investors if held until maturity. Even bond funds (most of which don’t mature on a specific date) generally offer some limited downside unless they’re invested in a high-risk asset class. In contrast, even the most conservative segments of the stock market offer no such guarantee. All stocks—even the safest stocks—experience periods of volatility. There are no guarantees when it comes to stock investing. Investors who hold stocks should always prepare for unanticipated losses.
