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Synthetic Bonds

A "synthetic bond" is typically a combination of derivative and other non-bond instruments which can generate a predictable rate of return over a specified period of time, and which, upon maturity, can return the investor's original principal intact. These combinations can be designed with maturities from 1 week to several years.

Turning the S&P 500 Into a "Synthetic Bond"!

Consider the world's largest ETF, which carefully tracks the S&P 500 Index, symbol "SPY".


SPY collects all of the dividends generated by the companies in the Index, and after a minuscule management fee pays them out to the ETF's shareholders as quarterly dividends.


These dividends are NOT heading toward zero! In fact, with rare exceptions, they generally INCREASE each year, with those annual increases averaging 7% - 8% in recent years.


Based on recent average prices for SPY, the ETF's dividend yield in 2020 should be around 2%. That, of course, compares very favorably against even the 10-year Treasury yield of 1.6%, which could be heading even lower. That advantage could become even greater on an after tax basis. *


But, of course, SPY is not a bond! Simply buying the ETF to get that dividend could result in substantial losses if the S&P declined. So a combination of derivatives is used together with SPY to create a "synthetic bond" which not only captures the ETF's dividends, it virtually eliminates any market risk. 


In fact, the derivatives themselves can occasionally generate additional income, pushing the yield closer to 3%. This additional income would also get more favorable tax treatment than straight interest-paying instruments.*


Bottom line: The "synthetic bond" provides an INCREASING stream of income in a tax -advantaged instrument with little or no market risk. Conventional bonds are paying a DECLINING amount of interest...possibly heading toward ZERO...fully taxable at ordinary income rates.


* Any income generated by the derivative components of the "synthetic bond" are taxed as 60% long term capital gain and 40% short term. The SPY dividends may be taxed as low as 15% as "qualified dividends", but you should discuss this with your tax preparer.


What Happens If Everyone Is Wrong?

Let's consider the possibility that interest rates stop declining soon and start back up.


I. If you own conventional bonds that mature in a few years or longer, you are going to see your bond PRICES DECLINE DRAMATICALLY, until they return to par at maturity. Rising yields mean lower prices. You would not be in a good position to switch into higher yielding bonds.


II. If you own "synthetic bonds", you will be collecting ever INCREASING dividends. You will also be in a position to switch into conventional interest-paying instruments if and when interest rate levels make them more attractive than dividends. There would be virtually no loss involved in selling the "synthetic bond" at any time prior to its "maturity".


III. You could, of course, hold short term interest-paying instruments...T-Bills, CDs, etc...waiting for higher rates to develop, but their yields both pre-tax and after tax are already lower than the "synthetic bond" yields. (But if interest rates don't rise, or continue to decline, you're going to be earning less and less, while "synthetic bonds" are paying more and more!)