Q: I keep reading about how I should be looking for bond proxies as a replacement for term deposits and bond funds, now that interest rates are so low. What are bond proxies and are they really going to be a good replacement for my fixed income investments?
A: Bond proxy is a term that describes stocks with predictable income returns that can act as a substitute for fixed income securities in an investment portfolio.
The types of companies that are often classified as bond proxies include infrastructure businesses, real estate investment trusts and consumer staples. Infrastructure stocks include companies that operate toll roads, ports, airports, rail facilities, electricity power lines and gas pipelines.
These companies tend to be less exposed to the business cycle: many infrastructure assets have regulated income; REITs earn income from long-term leases; and consumers continue to shop for their consumer staples whatever the economic conditions. So, they may provide capital stability in combination with a steady income return.
Bond proxies are an alternative to cash and fixed income and are popular at times when interest rates and bond yields are low, as they are now.
As a source of income, shares come with greater risk than cash or bonds. But as a sub-class of shares, bond proxies tend to be more defensive in character – they may not rise as much as the overall market when equities are rising but they should not fall as much in a bear market.
Because demand for bond proxies is linked to movements in interest rates, there is a risk that when interest rates rise bond proxies will be sold off as investors switch back to safer income producing assets.
In the current environment there is little expectation that rates will rise over the coming year or even longer.
Some commentators argue that the term bond proxy is a misnomer, that bonds and cash have characteristics that cannot be approximated by owning shares. For example, a term deposit or bond investment involves the promise of a return of capital at the end of the term There is no such promise when you buy shares.
They point to events in global markets in 2013, when the US Federal Reserve signaled that it would start to reverse its quantitative easing strategy and start to normalize rates. There was a sharp sell-off of bond proxies.
Bonds sold off in mid-2013 but income-oriented equity investments performed far worse.