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The search for a bond substitute has been about as lunatic as Don Quixote’s quest for a fantasy world. Why a substitute for the Great Diversifier anyway? Because when interest rates move higher, bonds and stocks disintegrate in tandem. In the scourge of 2022, Vanguard’s total bond ETF lost 13%, not much better than the broad market’s -18%. Seeming more like de-worsification than diversification, the twin collapse spooked adherents of the venerable 60/40 portfolio.
But almost all of the vaunted replacements for bonds put forward by fixed-income detractors have come to naught. Probably the most frequently proffered bond proxy is the utilities sector. After all, utilities escaped the 2022 market debacle without a loss. But its dividend is a shabby 3% and it carries a volatility almost as high as the S&P’s, so that its fabulous 17% run through July of this year could just as easily be reversed.
What about real estate investment trusts? Uh-uh, same problem as bonds, higher interest rates pummeling the group to a 26% washout in 2022. Besides, the much-ballyhooed but pedestrian dividend yield of about 3.9% is hardly as high as the interest on your money market cash.
We can pretty much dispense with the master limited partnership alternative to bonds. Despite their ample dividend (about 7%) and spectacular performance in 2022 (+26%), MLPs are no less nervous than the market as a whole. In addition, we note the oft-repeated demonstration that their fee-for-transport source of income is not immune from the whims of oil prices. The master limited partnership is, first and foremost, beholden to the energy sector.
Last we come to high dividend-paying preferred stocks. But this candidate for bond surrogate has a tragic flaw—preferreds are primarily issued by banks and other financial entities. Hopefully, you weren’t there for the demolition of financial institutions that accompanied the Great Recession of 2008.
Now, many observers—including apparently many HD readers–have been smitten with the latest fashion in bond replacement. Could that really be the JPMorgan Equity Premium Income fund (symbol: JEPI), the glamorous option-income offering that has pulled in more assets than any other actively managed ETF? The same one that has failed to live up to the hype that it provides viable low-volatility competition for the S&P?
How can I be so arrogant and so sure? Easy. In 2023, when the broad market gained 26%, JEPI could only scrape together an advance of 10%. Likewise, the rambunctious S&P’s 18% romp so far this year blows JEPI’s 10% total return out of the water. As has been the case over more than twenty-five years, the cap placed on appreciation by an option-income fund’s short options takes a big bite out of its total return.
But might JEPI re-emerge as the Holy Grail for bond-substitute chasers? Count me as dubious. Nowhere in its glitzy presentation does J.P. Morgan promote the fund as a proxy for the bond sleeve of a diversified portfolio.
Yet, as a social scientist avowedly open to any hypothesis no matter how remote, I proceeded to examine the relevant data. I am duly humbled by what I found. To my astonishment, the many readers who are using JEPI as a replacement for a bond fund may be justified in their thinking.
How can I make that claim? I did an analysis comparing relevant data from JEPI to those from two bond fund benchmarks. I felt one standard should be Vanguard’s total bond ETF (symbol: BND). The other, I thought, should be a Vanguard high-yield (junk) bond fund whose performance would be somewhat sensitive to changes in stock prices. Since Vanguard apparently does not have a high-yield bond ETF, I used the group’s high-yield bond mutual fund (symbol: VWEHX) as the second yardstick.
Here’s the nitty-gritty. Although JEPI’s cost is very reasonable for an active fund (.35), it is higher than it is for either of the bond criteria. But the Morgan Stanley offering makes up for that and more through its higher dividend (now about 7%) than for total bond (3%) or even high-yield bond (6%).
All three funds pay their dividends monthly, but those distributed by JEPI have some singular characteristics. Its income is derived primarily from sold options rather than from stock dividends per se, which are diminished by many holdings that pay small dividends and a few that pay none at all. Since option players are willing to pay more when the market is jumpy that when it is not, income from JEPI’s option sales varies with fluctuations in stock prices. The dividends paid by bond funds do not change nearly as much or as often.
On that basis, JEPI’s interest rate has ranged historically from its current 7% to 12%, so that it will almost always be as high or higher than it will be for the two benchmark bond funds. On the flip side, the unsteadiness in the rate could be a non-starter for retirees requiring a constant income stream to cover month-to-month living expenses. All dividends, from JEPI as well as the bond funds, are taxed as ordinary income, encouraging avoidance of taxable accounts.
Any comparison of the quality of a stock vs. bond portfolio is dubious at best. Still, it seems safe to say the quality of JEPI’s largely blue chip 100-plus holdings is considerably higher than that of the often struggling companies in the high-yield (junk bond) space. But as a stock market sensitive fund, isn’t JEPI more jittery than our two bond benchmarks? Yes, but not by as much as you might think, because JEPI’s short options work as a brake on small declines.
Take 2022, when both stocks and bonds were hammered by a spate of relentlessly higher interest rates. Perhaps more than anything else, JEPI’s performance that year propelled it to the top of the heap of bond-surrogate wannabes. It lost only 4%, as against 13% for total bond and 9% for high-yield bond.
Okay, but what about upside? Remember, performance was JEPI’s Achilles heel as a challenger to the S&P. But, as a bond fund proxy, its return looks quite acceptable, in between the performance of the two bond benchmarks last year and leading them both so far this year.
What have we learned? Though a stock market-based ETF, JEPI compares more favorably as a bond substitute than most of the more conventional bond alternatives, like utilities or real estate investment trusts. Don Quixote may have been frustrated in his quest for a more virtuous world, but some of our own readers may have succeeded in their search for an evidence-based surrogate for the beleaguered bond fund.
Thanks for the interesting discussion Steve. When it comes to stocks, I’m very much a buy-and-hold kind of person. But when it comes to bonds…sometimes I’m in, and sometimes I’m out. It was pretty easy to see this last cycle, what was going to happen to bonds of any duration, once interest rates started rising–they were going to get clobbered, and clobbered big-time. And the Fed clearly communicated what it was going to do, and even when. I’m sorry about cluttering your post with this kind of market-timing heresy, but on the bond side, what was going to happen this time around was clear as day. It was quite easy for me to swap out my medium term bond holdings for short-term positions, and worked out quite well. And I might further add, with the Fed getting ready to cut rates, I have no quams about moving some assets back to medium bond funds again.
I know it’s not exactly set it and forget it, but we live in an ever-changing world, and sometimes we need to adjust our thinking a little. Thanks again for the discussion.
I suffer from the same weakness. What is a medium-term shift and what is just a “trade?” Perhaps the truth is in the pudding. Does the violation of a pure buy-and-hold strategy usually work for you or not?
Trade vs shift–it can be a fine line sometimes. I have several different “vehicles” that I move around among, including CD’s, bond funds, Treasury Bills, bonds and notes; I-bonds, TIPS, and here recently just plain old money market funds. It seems that I haven’t gotten the “set it and forget it” memo for this stuff, and it seems like the ideal instrument changes every few years. So yeah, not sticking with buy-and-hold strategy for bonds has worked out pretty good– although, when we picked up some I-bonds many years ago with a 3%+ inflation rate, I had the good sense to hold onto those. So if I do find something good enough to hold, I’ll do it. Otherwise, I’m usually forced to move around if I want to maximize yield, and/or minimize loss.
It is unusual on the site to find readers who move things around and are successful doing it. I Bonds were great while inflation was rampant and you always know you are keeping up with inflation. But a soon-to-be low return—especially when money market rates are so high—dampens enthusiasm for I Bonds for many people, as does their poor liquidity.
Yep, I totally agree on all points. I also must confess to having access to the Federal Employee Thrift Savings Plan “G” fund, which is a very unusual instrument in that it has the liquidity of cash but the (approximate) return of 5-year CD’s. It has demonstrated its worth on many occasions, and I don’t think we’d have been as successful without it.
I’m intrigued by your discussion–and the reader comments– about JEPI, and its potential to be a partial bond stand-in.
Wow, it’s always gratifying to learn an article helped a reader!
This was what academics call authoritative. I wonder however, why you, like oh so many financial pundits, always seem to leave out the bond substitute Annuities.
I am not personally an authority on bond substitutes, but I taught Financial Planning and Retirement Planning, as well as Life insurance Planning as a college professor for the last 15 years, as a primary instructor in the CFP, ChFC, CLU and RICP professional. designation programs of The American College.
Two of my colleagues , Dr.Wade Pfau and Dr.Michael Finke are authorities in this field, most notably Wade Pfau. His work introduced me to the concept of annuities as bond substitutes.
The purpose of bonds in most portfolios is to balance the volatilities of equity. In the 60/40 portfolio, which for decades has been and still is the standard recommendation from most financial advisors. for retirees, it has been successful. However, in 2022, for only the 6th time since 1926, they failed to counterbalance the dramatic losses in equities and actually joined them in a free fall.
In June, 2023 when I decided it was time to retire, I pursued 4 annuities. I made my retirement effective January 5th, 2024, instead of December 31, 2023, (in order to get my final checks in January, and thereby be eligible for Roth Contributions one more time.) Of the annuities I purchased, three were funded by Roth Dollars and one was funded with traditional IRA dollars. Waiting slightly longer than the required one year minimum to turn on my income streams, in the last three weeks, I finalized the process to start receiving income streams. By waiting until the day my wife turned 70, as she is the younger of us and I purchased joint life annuities, the income payout increased 1.5%. Because I have secured guaranteed income to complement our Social Security benefits, my wife and I will enjoy a taxable income minimized through proper planning of slightly over $100,000 annually. Projecting our taxes over the next 5 years, we will pay between Zero and $2,100 in Federal Taxes, and after 2024, Zero in state taxes, as my state doesn’t tax SS Benefits.
Five years from now, the two remaining annuities, which are growing at a guaranteed internal income account rate of 8.25%, we will receive additional tax free income from our two remaining annuities. Because I purchased the annuities from one of the few A rated Carriers that allow “piecemeal Roth Conversions with in their products,” over the five years I will be converting the annuity which was funded with Traditional IRA dollars to a Roth Annuity, paying the taxes, as I go, from external brokerage account dollars. From 2029 forward, the income we will be receiving, excluding the Social Security Benefits growing annually through the SS COLA, we will enjoy minimal taxes because the majority of our income with not be income taxable.
As far as “Fixed income goes,” we have it covered without a single bond. No JEPI, no more BND or VTBLX, just annuities. Guaranteed income annuities.
Where are our equities? Where most people should have the money, at Vanguard, invested in VTI (or VTSAX, if you prefer mutual funds.) 90% of our equities are in VTI and 10 percent are in VXUS, since the common belief is you need Non-US exposure. I am not sold on that, but why have an advisor if you don’t listen to them, right. So he gets 10% for VXUS.
Do I worry about the need for balance and diversification? Absolutely, that’s why I own the entire market. Not sectors, or overweights in this or that…NO! The whole market, world wide.
We also have 2.5 years in cash, earning 7.25% in July, 7.12% in August and 6.38% starting September 1st, for September. I will know October’s rate in 6 days. These funds are in a Reverse Mortgage Line of Credit, yet another income tax free source of emergency funds, not currently being needed for a comfortable retirement, but there, “just in case,”
In my “Fun Money” personal account I hold a single stock, BRK-B. Because Vanguard policy for managed money doesn’t allow more than 5% in a single, non Vanguard stock, I moved it from my managed account to my self managed account. I guess, technically, I should lower the VTI/VXUS holdings by a combined 5%, as that is the percent of my overall, non annuity holdings represented by BRKB.
I have noticed that HD readers aren’t really keen on annuity products, or at least I haven’t seen those article yet. They really do deserve careful consideration, because like life insurance, nothing in the market place, not stocks and not bonds, can do the job of either of these insurance based “transfer of risk” products.
Happy Retirement one and all.
Could you elaborate on this?
“We also have 2.5 years in cash, earning 7.25% in July, 7.12% in August and 6.38% starting September 1st, for September. I will know October’s rate in 6 days. These funds are in a Reverse Mortgage Line of Credit, yet another income tax free source of emergency funds, not currently being needed for a comfortable retirement, but there, “just in case,”
I understand that if you draw from this line of credit, these withdrawals are tax free. But your first statement confuses me, as I have never heard of a Reverse Mortgage Line of Credit earning interest paid to the borrower. I was under the impression that the unused portion of your Reverse Mortgage Line of Credit will increase over time at a specified growth rate, but this isn’t interest earned and paid to the borrower. For any withdrawals you make, you’re not obligated to make payments but there is loan interest charged and added to the loan balance.
Further clarification would be appreciated.
Brent…
When interest rates skyrocket, rates on variable rate Reverse Mortgages, which are the majority of reverse mortgages, increased as well. One of the provisions of reverse mortgages includes the requirement for Mortgage Companies to credit your LOC at the same rate of interest they are charging on your outstanding mortgage. It is not “paid to the borrower,” exactly, but as you will see, the benefit is the same, as the funds become available to the borrower, upon demand.
So, as an example, in July, my outstanding mortgage had a 7.125% rate. My line of Credit increased by $1,524.38. The interest paid on my outstanding mortgage balance was $502.32.
The reason my LOC is earning interest in this manner is because in 2023, when I decided to retire, I took a large sum from my brokerage account and paid my “HECM for Purchase” Reverse Mortgage down to a “de minimas” amount, in order to keep the loan active and thereby keep the LOC active. I actually had it paid down to $100.00 from June 20123 through January 2024.
FYI, a HECM for Purchase Reverse Mortgage is one where when you build/buy a new home, you put down a very large “down payment,” and the Reverse Mortgage represents the difference. In our instance, we “put down” $184,000 on a $350,000 home on 6 acres. HECM for Purchase loans are NOT the typical Reverse Mortgages traditional used by most Seniors, but they can be quite beneficial in the right circimstances.
In January, 2024 I bought and paid for a Car Cash and in April 2024 paid my 2023 Taxes, using the LOC. I currently have a $425K home with a mortgage balance outstanding of $88,925.50. While no payments will ever be due on this loan balance, as longs either my wife or I are living, I always have the option of paying into the Mortgage, and simultaneously lowering the mortgage balance and increasing the LOC, dollar for dollar. If I choose not to, over time, the outstanding balance will grow, as will the LOC.
As you indicated, the Line of Credit growth is guaranteed in the contract, but I have chosen to put mine on steroids, by paying in the large amount mentioned previously.
It is highly unlikely that either of our children will ever live in this home, as they live in different states, but upon our demise, any equity remaining in the property, after paying off any mortgage balance, will go to our Revocable Trust, and the proceeds will then be disbursed in accordance with that trust’s provisions to our children.
Hopefully I answered your question!
Wow, so much sophistication in less well traveled products! I suspect the hesitancy of HD readers about annuities has to do with cost, a primary concern on the site. For some, the upfront commission and provider’s cut of the income or stock gains are prohibitive. But it sure is comforting to get that reliable hands-free check.
HA! Thanks Steve.
Yes…I possess a great deal of knowledge and experience with insurance and financial services products.
I also know that much of the concern expressed by people regarding annuities and other risk products is based on FEAR…False Evidence Appearing Real. This false evidence is often perpetrated by those with an agenda. Fees and commissions on SPIAS, the most common used Annuity for retirees have limited fees and are available today in low-load and no-load form.
The commissions and fees on annuities, rather than being “prohibitive,” as you stated, are usually one time charges vs. the ongoing, never ending, AUM fees of 1.0″ to 1.5% annually, which of course are levied regardless of performance or level of actual services rendered.
You are 100% correct, however, about the enjoyment and comfort one receives as their check is deposited, month after month, year after year, for as long as you or your spouse live. (All my annuities are joint & survivor, by choice.)
JEPI did what it was supposed to for me in 2022. It was touted as less volatile than the market and it lived up to that. I’ve kept it in my portfolio, though at less than 5 percent. Its returns have been okay but obviously lag S&P or total market index funds in 2023 and 2024. I’ll continue to hold it for now.
One point I’m not sure is addressed is JEPI’s risk. Compared to bonds, JEPI is much riskier, both because it’s a stock fund, but also because of the ELNs from which it gets the majority of its payout. Those have manager risk – we have to hope the fund’s managers sell sensible options at a good price – and they also have counter-party risk, mainly the banks and other institutions buying those options. J.P. Morgan mitigates some of that risk by spreading it around amongst more than one entity, but it’s still there.
So the bottom line is that JEPI can’t really be considered a bond substitute because the risk profile is completely different (much riskier). Does the yield make up for the risk? That’s a good question.
You may be selling yourself short. As I mentioned, JEPI has performed quite admirably as a bond substitute over the last couple of years, particularly in the 2022 selloff, when it lost only 4%. In addition, it only fluctuates about 60% in relation to the broad stock market.
Why not JEPI
-An investor should look at 2 things: Total returns (which includes the income too) + SD=volatility. Many confuse high income with returns.
-An investor can generate monthly income, even high one, from stocks too. Fidelity FXAIX=SP500. You can set up in 2 minutes a monthly sale of $4K(or another amount) on a specific date to run for years.
-JEPI monthly distributions are shrinking. It started at about 12% annually and now is about 6%
-JEPI is a covered call solution. I have researched and tested many alternative solutions, and none were good longer-term. It is based on the managers capabilities, and eventually they make mistakes, or suddenly it does work.
-JEPI volatility is lower than SPY but higher than typical bond. 2022 was a unique year; when was the last time the US total bond index lost so much? None for at least 25 years
-What about allocation funds? Look at PRWCX,FPURX,FBALX. See chart(https://schrts.co/emwDZqFJ).
-CEF is another option for leveraged income bonds. They pay a lot more income but the volatility is higher than bonds and sometimes more than stocks. Again, it works until it doesn’t.
-Most should keep it simple
-Remember: high income should never lead your decision. It should be based on Total Returns.
If you want to learn more about why not covered calls, read
https://caia.org/blog/2024/02/24/covered-call-strategies-uncovered
See below the first 2 paragraphs
SUMMARY
Covered call strategies aim to offer index-like returns with lower volatility and higher yieldsThey have underperformed their benchmarks significantly over longer periodsThey are tools for market timing, but that is difficult to execute successfullyINTRODUCTION
JP Morgan has been a late-comer to the ETF industry, but achieved remarkable success in the actively-managed ETF space as it manages the two largest products, namely the JPMorgan Equity Premium Income ETF (JEPI) with $26 billion and JPMorgan Ultra-Short Income ETF (JPST) with $24 billion of assets under management.
Intuitively, investors might have expected growth or value-focused products from well-known active managers like Fidelity or PIMCO to dominate, but instead, JEPI represents a covered call strategy.
JEPI represents a portfolio of large-cap stocks that is combined with selling call options to generate monthly income. The objective, like for all covered call strategies, is to offer index-like returns with lower volatility but higher dividends. In this research article, we will explore if covered call products have been able to meet these goals.
As previously indicated, we like JEPI as a sort of “bond surrogate” which provides us comfort to maintain a higher overall stock allocation than we might otherwise. JEPI has performed well and pretty much as advertised. JEPI should not beat stocks over the long term, but probably should beat bonds. JEPI is far less volatile than stocks, and will moderate stock downturns such as in 2022.
We first bought JEPI 3.5 years ago, and its valuation is essentially breakeven. Over that time, JEPI has distributed about 30% (11,9,7,& half a year 3.5 %) for an annualized return of at least 8.5%. The S&P 500 has risen about 33% in that time.
We bought more JEPI in late 2022. Since then, JEPI’s valuation is up 4-10% and it has distributed about 14%. JEPI’s annualized return has averaged at least 14%. The S&P 500 has risen about 47%.
JEPI beats bonds but clearly lags stocks when the market is strongly rising. JEPI also has broader stock diversification than the S&P as it is not so heavily weighted to the Magnificent Seven.
With stable markets, JEPI’s long term distribution rate is projected to level out in the 6-7% range. JEPI’s original high payouts were when the VIX volatility index was 30, not 15 as today. I also have a concern that as JEPI grows ever larger, its managers may be challenged to to capture the required volume of options since large tranches of options can move a stock and it’s options pricing. Thus, I am keeping a watchful eye on JEPI for the longer term.
In sum, JEPI has performed well for us as a bond surrogate, but this could change in the future. I’m personally not a huge bond fan, so I like JEPI for its stability and yield. Still, JEPI may not be for everyone as you could probably get similar performance with a correctly managed stock to bond allocation.
John,
I’m so glad you read the article! Your comment a few days back is what motivated me to write it. It doesn’t surprise me any more when I learn as much from HD readers as they learn from me. Thank you.
Steve, I’m a little confused when you refer to JP Morgan and Morgan Stanley offering JEPI. Could you elaborate why the two institutions are mentioned interchangeably in offering JEPI?
I am aware historically how the two names came about, but I must be missing something as to which one owns JEPI based on your article.
Olin,
J.P. Morgan offers JEPI and many other active ETFs, not Morgan Stanley. Thanks for catching that!
Are not bond returns taxed similarly as ordinary income ? Thanks for the response in advance.
Yes, you’re right. I mention that in the article, but I guess I wasn’t clear enough.