What Is a Bond Proxy?
Definition & Examples of a Bond Proxy
A bond proxy is an investment product (other than a bond) that supposedly replicates the performance of a bond while offering relatively higher yields. The term "bond proxy" is a bit of misnomer—while some stocks do share characteristics with fixed-income investments, it isn't accurate to assume that anything other than a bond will act like a bond.
Here's what you need to know about bond proxies and a look at how they've performed during a previous stock downturn.
What Is a Bond Proxy?
Bond proxies are investment areas whose performance resembles bonds, but with the added benefit of higher yields. In theory, bond proxies have stronger price stability than other stocks. So, if the stock market falls broadly, then bond proxies may experience less of a price decline—similar to how bonds perform during these same events.
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 coupon payments from bonds.
While some stocks do act more like bonds than others, it isn't safe to assume that bond proxies will truly replicate the bond market's performance. If you're looking to hedge your portfolio with bond exposure, then the safest investment is a bond investment.
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.
Real estate investment trusts (REITs) and utility stocks are examples of bond proxies. 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 may have less of an effect on REITs. Utilities often enjoy natural monopolies, and basics like internet service and electricity are among the last costs a family will cut to save money.
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: iShares Select Dividend ETF (DVY), -6.02%
- Utility stocks: Select Sector SPDR-Utilities ETF (XLU), -9.35%
- Real Estate Investment Trusts (REITs): iShares U.S. Real Estate ETF (IYR), -15.71%
- Master Limited Partnerships (MLPs): Alerian MLP ETF (AMLP), -3.94%
- Preferred stocks: iShares U.S. Preferred Stock ETF (PFF), -5.53%
- Convertible bonds: 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—and most likely will—lag behind bonds.
It’s important to keep in mind that this data reflects only one month of performance. Looking only at one month of data doesn’t reflect the fact that equities tend to provide superior returns to bonds in the long-term.
A Warning About Bond Proxies
Bonds are fundamentally different than stocks, so it's incredibly misleading to suggest that any stock is like a bond. Unless an individual bond defaults, it will eventually return the full amount of principal to investors upon 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.
The bottom line is that you shouldn't seek higher levels of income from bond proxies unless you can afford to withstand short-term losses.
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.
- Bond proxies are investments (usually stocks or ETFs) that, in theory, replicate the price stability of bonds while offering higher levels of income.
- Bond proxies become especially popular when interest rates are low and bonds offer little fixed income.
- Investors should proceed with caution while investing in bond proxies—while they may be relatively safer than other stocks, they are inherently much different from bonds and they offer fewer guarantees of price stability and income.