Bonds to Buffer Income ETFs?

Stocks tend to outperform bonds over long time horizons, but with significantly higher volatility. The current outlook for both stocks and bonds going forward appears less promising due to relatively low bond yields and elevated equity valuations. Still, many investors continue to increase their exposure to stocks to make up for what have been historically low bond yields. Buffer Income ETFs offer an alternative with a built-in level of downside protection. Buffer Income ETFs also have the potential to provide higher income than bonds, and with lower volatility than an unhedged stock portfolio. They provide a fixed level of monthly income, regardless of the performance of the reference asset (SPY) during the 12-month outcome period. The downside protection is for the first 9% or 15% loss of the reference asset, depending on the Buffer Income ETF series.

While investors have typically incorporated bonds in a portfolio to reduce volatility, they had a rude awakening in 2022 when bonds were highly correlated to stocks and both asset classes tumbled. U.S. 10-Year Treasury bonds lost 17.8% and BBB corporate bonds dropped 15.14% in 2022. The S&P 500 declined 18.04% (including dividends). It was a particularly miserable year for investors who thought their bond holdings would cushion their declining stock portfolios.

How can investors potentially increase their return potential without interest-rate risk in a bond portfolio? Let’s consider the use of Innovator’s October 2023 Premium Buffer Income ETFs as a bond replacement. Again, these two Buffer Income ETFs pay fixed monthly income while also providing some downside protection.

October 2023 Premium Buffer Income ETFs:

Here are 4 scenarios where investors can incorporate Buffer Income ETFs as a defensive, equity-based alternative to bonds:

Scenario 1: 60/20/20

Potential allocation: 60% Equities, 20% Buffer Income ETFs, 20% Bonds

An investor is concerned about rising interest rates and is underweight bonds. Rather than increase his allocation to unhedged equities, he can incorporate a Buffer Income ETF which can provide a high level of income without interest-rate risk. Depending on the level of downside protection desired, he could choose either the Income 9 Buffer or the Income 15 Buffer. The “15” pays about 1% less income annually, but provides more downside protection.

Scenario 2: 60/30/10

Potential allocation: 60% Equities, 30% Buffer Income ETFs, 10% Bonds

An investor is concerned about the low yields in his bond portfolio since they will not cover his income needs. To increase his income, he could incorporate Buffer Income ETFs to replace most of his bond portfolio.

Scenario 3: 50/25/25

Potential allocation: 50% Equities, 25% Buffer Income ETFs, 25% Bonds

An investor began the year with a balanced 60/40 portfolio, but high stock performance during the year has pushed the stock allocation up to 65% and the bond allocation down to 35%. Concerned about high equity valuations and low bond yields, the investor would like to reduce his unhedged equity allocation and also reduce his exposure to bonds. By incorporating Buffer Income ETFs in his portfolio, he can improve his income stream while reducing his unhedged exposure to stocks and bonds.

Scenario 4: 35/35/30

Potential allocation: 35% Equities, 35% Buffer Income ETFs, 30% Treasury Bills

An investor has a balanced 50/50 portfolio, but fears the stock market is nearing bubble territory as valuations are at all-time highs. In addition, bond yields are too low to provide the investor with the income stream he requires. He’d like to protect against a potential decline in the stock market, and also reduce his interest rate risk in his bond portfolio. By incorporating Buffer Income ETFs and 3-month U.S. Treasury bills in his portfolio, he can greatly reduce his unhedged equity exposure and eliminate interest-rate risk by swapping out of bonds and into short-term T-bills and Buffer Income ETFs. Note, T-bills are paying an annualized yield of 5.35% at the time he is considering this new allocation.

Summary:

For over a decade, investors have enjoyed strong returns from a traditional 60/40 portfolio, but the next decade may be quite different from the previous one. We still have historically low bond yields and relatively high inflation (although declining) which both pose threats to bondholders. While there are many alternative investments to choose from, very few provide a liquid defined outcome that offers both much-needed downside protection and a high level of income. With lower returns possibly on the horizon for a traditional 60/40 portfolio, Buffer Income ETFs offer a potential solution for investors looking for alternatives to bonds.