JEPI as a Bond Substitute? Don Quixote Confronts the Windmills

Steve Abramowitz from Humble Dollar delves into the unexpected performance of the JPMorgan Equity Premium Income fund (JEPI), a fund often touted as a low-volatility option for investors seeking income.

Contrary to popular belief, Abramowitz’s analysis suggests that JEPI could be a viable substitute for bonds, offering a competitive dividend yield and relatively stable returns, even during market downturns.

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.

Credit: Steve Abramowitz from Humble Dollar