Bonds deserve a place in a diversified portfolio, but they will not provide the ‘lifeboat’ that is needed when equity markets are in turmoil, according to John Archbold, client portfolio manager at Aptus Capital Advisors, a financial services firm headquartered in Fairhope, Ala., with $4.25 billion in AUM.
An overreliance on bonds for diversification will put a drag on portfolios when the equity markets are in a downturn or are beginning to recover after a slide, Archbold said in an interview.
“In our view, excess exposure to bonds can impede your return during bull markets, while their performance during periods of upheaval will not compensate you enough for that return drag,” he said.
Portfolios need other alternatives to the standard equities and fixed income that are often relied on by advisors, he said. The use of put options can be one of those needed alternatives to provide protection from equity turmoil when bonds will not do the job, he said.
A put option is a contract giving the option holder the right, but not the obligation, to sell a specified amount of an underlying security at a predetermined price within a specified time frame. The predetermined price at which the holder of the put option can sell the underlying security is called the strike price, and can provide more value and protection than bonds, which can be unsellable in a tumultuous market, Archbold said.
“If you want to monetize these positions, that is sell them to create cash when needed, good luck finding someone to give you fair value when you need it most,” the portfolio manager said. “It is inefficient to rely on bonds.”
Archbold suggests advisors create portfolios that use something closer to a split of 75% equities and 25% put options.
“Until 2022, returns on bonds barely outpaced inflation,” he added. In a market situation such as the sell-off caused by the 2008-2009 market crisis and the crash in early 2020 caused by Covid, bonds did not offer the safety net that many investors anticipated, he said.
“We want advisors to think through who is going to buy the assets and why when cash is needed,” he added.
Uncertainties such as the U.S. presidential election, interest rates and economic growth could disrupt the market, Archbold noted.
When there is a crisis, many bond holders may be trying to sell in order to create cash to take advantage of the equities low points, he said.
“Puts, on the other hand, function differently. They will go up in value when the asset they represent goes down,” Archbold said in a recent blog post.
“Should something unexpected happen in the market, you will have more choices because you have something that can potentially be converted to cash," he said. "You are holding protection that other market participants need and are incentivized to pay you for.”
Bonds do not offer the same type of protection, he said. Put options allow the investors to hold portfolios that perform well in various environments and offer true protection during downturns, he added.