A few decades ago, Treasury bonds paid over 15% interest. Today, you’re lucky if you can get 2-3%.
Yet bonds remain a core tenet ofretirement planningorthodoxy. Try telling an investment advisor that you don’t want any bonds in your portfolio and they’ll burst a blood vessel.
I admit freely, though, that I don’t invest in bonds at all. Nor do I plan to start as I get older.
Instead, I fill that niche in my portfolio with private notes and a combination of investments that include crowdfunded passive real estate investments and rental properties.
Why Inflation Wrecks Your Bond Returns
Most bonds pay a fixed interest rate. You earn interest payments until the bond matures, then you get your original investment back.
Imagine buying a one-year Treasury bill (short-term bond) that pays 2% interest. At the end of that year, you’ll end up with your original principal plus 2%.
But if inflation rages at 8.5% as it has over the last year, you’ve effectively lost 6.5% on your investment. Sure, you earned 2% interest, but you lost 8.5% in purchasing power.
Granted, you can buy bonds that pay 10%, 15%, or 20% interest. But they come with a high risk of default, defeating the entire purpose of bonds for most investors.
The Role of Bonds in Your Portfolio
Bonds offer several types of protection for investors as they near retirement.
To begin with, bonds come with far less volatility than stocks.Stock markets are prone to sudden lurchesand drops, which is fine for workers who can buy in at a discount, but retirees typically sell off their stocks to cover their living expenses. Retirees have to sell more of them when stocks slide in value to cover their bills and empty their nest eggs faster.
And while bonds may fluctuate in value on the secondary market, retirees can buy and hold them for consistentpassive income. Income that retirees can rely on month in and month out.
Finally, bonds offer diversification from the stock market. The stock market may crash, but bonds often go up in value when it does. The lack of correlation betweenstocks and bondsmakes them useful hedges against each other.
Can Real Estate Replace Bonds in Your Portfolio?
The more you know about real estate investing, the lower your real estate investment risk. But even so, you have several options that don’t require any knowledge, skill, or labor on your part.
This is great because older workers are particularly behind the curve on retirement savings. According to a study by Clever Real Estate, theaverage baby boomer has just 30% of the recommended retirement savings— and not much time to catch up.
That means they’re going to need a helping hand from higher returns on their investments rather than relying on low-yield bonds to get them to the finish line.
Real estate investments come in many flavors, so here are how several broad categories stack up as bond replacements.
Direct Ownership
You can buy income properties directly, of course. They generate ongoingcash flow, don’t require you to sell off any assets to keep collecting and allow owners to adjust rents for inflation.
Nor are you limited to vanilla rental properties. You can also create passive income with mobile homes,mobile home parks,self-storage, and every other niche under the sun.
But direct ownership comes with its downsides too. It takes labor and skill to find good deals. Each property requires a hefty down payment, making it hard to diversify among your real estate investments. Properties also require ongoing management, from repairs toevictionsto filling vacancies.
So, while properties do offer passive income, diversification from the stock market, and more stable prices and rents, they come with risk and work for the average inexperienced investor. That makes them a practical replacement for bonds, but only for experienced investors.
Crowdfunded Property Loans
You can invest money toward hard money loans secured against real estate in today’s world. Some platforms let you do so with as little as $1.
For example,Concreitpays a 5.5% annual dividend, paid weekly, and you can withdraw your money at any time. The underlying investment is a pool of short-term loans secured by real property. You can invest in increments of $1.
Or considerGroundfloor, which lets you pick and choose individual hard money loans to fund. You can put as little as $10 toward each loan, and the loans typically repay within 3-12 months. These loans pay between 6.5-14% in interest.
These passive real estate investments require no skill or labor to invest, and they’re secured with low-LTV loans. If the borrower defaults, the lender forecloses to recover your (and their) money.
Examples like these offer a viable alternative to bonds for the average investor. They come with low to moderate risk but pay moderate to high returns.
Best of all, they don’t come with anytenant management headaches.
Equity Crowdfunding
Other crowdfunding platforms let you invest in pooled funds that own properties directly. Or, in some cases, a combination of equity and debt funds.
For example,Fundriseowns multifamily properties all over the country, along with debts secured against real estate.Streitwiseowns several large office complexes and pays an 8.4% annual dividend.
Other platforms let you buy fractional shares of individual rental properties. For instance,Arrived Homesenables you to purchase shares in rentals for as little as $100 per property. They handle acquisition and management (for a fee), leaving you with a fully passive real estate investment.
They share little correlation with the stock market, generate ongoing income, and don’t come with stocks’ volatility. Again, these investments come with low to moderate risk but pay moderate to high returns. Last year, Fundrise averaged a 22.99% return across its assets, and you can invest with as little as $10.
What to Avoid
Whatever their merits, publicly-traded REITs don’t make a great bond replacement.
Because they trade on public stock exchanges, they share far too much correlation with stock markets. That removes their diversification value.
Also, public REITs offer little growth potential.REITs fall under unique SEC rulesthat require them to pay out at least 90% of their profits each year to investors in dividends. While that sounds great on paper, it handcuffs their ability to reinvest profits into growing their portfolios.
And if their share prices fall, which happens all too often, so do their dividend payouts. That makes them unreliable sources of passive income.
Final Thoughts
I don’t invest in bonds. Instead, I fill their niche in my portfolio with a combination of rental properties, real estate crowdfunding investments, and private notes.
One criticism I sometimes hear from traditional investors is that bonds offer liquidity that real estate doesn’t. While that’s true, some real estate investments are much shorter-term than others. Rental properties and most real estate crowdfunding platforms come with a minimum time frame of five years or so, but real estate loans often come with time frames measured in months, not years. I can pull my money out of Concreit at any time with no penalty to my principal. Every week, I get repaid for Groundfloor loans I made a few months ago.
And, of course, stocks offer instant liquidity, should the need arise.
The traditional approach says bonds lower your risk. But they only reduce one type of risk: default. Meanwhile, they leave you completely vulnerable to the risk of inflation — as all too many investors are finding out firsthand today.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
