Beyond Bonds: Buyer Beware

NEW YORK (TheStreet) -- As we exit the low interest rate era and return to rising rates, bonds and other fixed income instruments will come under selling pressure. This means in 2014 investors will be hunting for bond replacements in order to help safeguard their portfolio without having to account for falling bond prices and volatility.

Some investors will migrate to one or more of the hybrids -- floating rate securities, step-up bonds and Treasury inflation protected securities. However, I'm seeing sophisticated investor moving into some questionable alternatives (in my mind) and I just want to highlight the downside and risks associated with those instruments.

In particular, I'm seeing investors discussing master limited partnerships, interest rate linked structured notes and bank loan products as if they were interchangeable with bonds. They're not and here's why.

Master Limited Partnerships

Master limited partnerships have become increasingly popular with investors seeking high yield investments in a low-interest rate environment. Generally, most, although not all MLP earn the majority of their "income" from energy related activities -- think oil or natural gas pipelines and you've pretty much got it.

To date, these have been investor "darlings." Two of the largest, the Kayne Anderson MLP ( KYN) and JPMorgan Alerian MLP ETN ( AMJ ) are up significantly this year. Each is trading at a premium to its net asset value.

MLP investors, like any other partnership, are considered unit holders. MLP investments receive different tax treatment than ordinary income producing investment. As such, MLP investors receive a K1 instead of a 1099, potentially negating certain tax deductions. Most significantly, MLP "income" is typically a combination of actual income and return of the investors' own principal. As such, the "true" MLP yield can be significantly lower than their cash-flow implies.

The takeaway: Given the lower "real" yield that is produced, as interest rates rise, the attractiveness of the MLP income potential is likely to decline.

Interest Rate Linked Structured Notes

Interest rate linked structured notes provide investors and speculators the ability to "bet" on the direction of a specific benchmark interest rate, for instance LIBOR or the ten-year Treasury. In November, Goldman Sachs ( GS) alone sold $1 billion of these floating rate instruments.

If the investor's thesis proves correct, then the IRL will rise in value, potentially generating above market rates of return. Conversely, if the thesis is incorrect, as a result of the aggressive nature of IRLs, investors could lose the entirety of their investment.

The takeaway: Interest rate linked structured notes should not be compared to bonds, as they are mostly used as speculative instruments and in seldom cases as part of a complex hedging strategy.

Bank Loan Products

Typically reserved for institutions and ultra-high-net-worth individuals, bank loan products are just as they name implies -- the investor is the lender.

The investment into bank loan products, typically structured in a fund format, is capital used to offer loans and other lending structures to third-parties. Moreover, most of bank loan products are structured as leveraged loans, thereby greatly increasing the risk associated with these instruments. Popular funds in this space include PowerShares Senior Loan Portfolio ( BKLN) and the SPDR Blackstone/GSO Senior Loan ( SRLN).

The takeaway: While these instruments can have significant returns, the risk is highly dependent on the skill and due diligence capabilities of the manager. In other words, with interest rate risk you lose the opportunity cost of yield but with credit rate risk, you can lose everything.

At the time of publication the author held GS.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Oliver Pursche is the president of GGFS, a boutique money management firm headquartered in Suffern, NY. Pursche is in charge of all business operations and serves on the firms' Investment Committee, Executive Committee and Board of Directors. Pursche is also a co-portfolio manager of the GMG Defensive Beta Fund (MPDAX).

Over the course of his career, Pursche has had the pleasure of working for venerable firms, such as PaineWebber and Neuberger Berman, as well as taking graduate courses at the University of Pennsylvania's Wharton School of Business. Most recently, Pursche published his first book, Immigrants: Unleashing the Economic Force at our Door.

Pursche is a trilingual financial services executive with more than 20 years of industry experience. His professional focus is on improving organizational structures and efficiencies, particularly in sales and the sales & marketing area. In the case of GGFS, Pursche helped four-fold AUM and five-fold revenues, as well as double profit margins from 2005 to 2013. Pursche accomplished this mainly through sales coaching, re-engineering the marketing processes and having an absolute focus on ROI.

Pursche is a frequent guest on CNBC, Fox Business News and Bloomberg Television. He also writes weekly columns for The Wall Street Journal Trading Deck, Forbes.com, Minyanville and The Street.

Pursche serves on the Advisory Board of the Cherie Blair Foundation www.cherieblairfoundation.org, which focuses on helping women entrepreneurs around the world. He is a member of the New York City Ballet Serenade Society and a member of the Advisory Board at Gemini Fund Services.

Pursche lives in Fairfield, CT with his wife Virginia and their two dogs. For a more complete biography, visit http://about.me/oliverpursche. Follow him on twitter @opursche

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