Bonds vs. Private Real Estate Debt

When someone tells me they want income, bonds are usually the first thing their advisor mentions. That makes sense. Bonds are the classic income investment, and for a lot of people they belong in the portfolio.

But a bond and a mortgage note are both loans, and that's where the similarity starts to thin out. The questions I ask are the same ones I ask about any loan. Who's the borrower, what backs the promise, and how do I get my money back?

The main kinds of bonds

• U.S. Treasuries are loans to the federal government, backed by its full faith and credit.
• Investment-grade corporate bonds are loans to companies with strong credit ratings. Most are unsecured, meaning they rely on the company's promise to pay rather than specific collateral.
• High-yield corporate bonds (sometimes called junk bonds) are loans to companies with weaker credit. They pay more because the default risk is higher.
• Municipal bonds are loans to states, cities, and public agencies. Interest is often exempt from federal income tax, and sometimes state tax.
• Bond funds and ETFs hold hundreds or thousands of bonds in one package and trade daily.

What private real estate debt is

Private real estate debt means being the lender on specific properties. Each loan is secured by a mortgage or deed of trust recorded against the property. You can do it by buying mortgage notes directly, or through a real estate debt fund whose manager buys, originates, and services the loans. The income comes from borrowers' monthly payments.

Side-by-side comparison

Interest-rate risk and mark-to-market

Here's the part a lot of income investors learned the hard way. When interest rates rise, existing bonds lose value, because new bonds pay more. The longer the bond's term (its duration), the bigger the price drop.

In 2022, when rates rose quickly, the Bloomberg U.S. Aggregate Bond Index lost roughly 13%. That was the broad, high-quality bond market, not a speculative corner of it.

If you hold an individual high-quality bond to maturity, you generally get your principal back at par, and the price drop along the way is temporary. Bond funds work differently. A fund has no maturity date. It keeps buying and selling bonds, so there's no date when it's scheduled to return to its old price. A loss in a bond fund may or may not be recovered.

Private real estate debt isn't priced by a market every day. A fixed-rate loan keeps paying the same contractual amount when rates move. That doesn't mean its value can't change. It means the value depends on whether the borrower pays and what the collateral is worth, not on what bond traders think that afternoon.

A promise vs. a lien

Most corporate bonds are unsecured. If the company runs into trouble, bondholders get in line with other creditors and wait for a bankruptcy process to sort out what's left.

A mortgage note is tied to a specific property. If the borrower stops paying, the lender has a legal path to that collateral, along with options like a loan modification, forbearance, or a deed in lieu. That's why I care so much about loan-to-value. The equity cushion is what protects the lender if the property has to be sold.

But I'll say this straight. Having collateral and being able to efficiently recover your capital from that collateral are not the same thing. Foreclosure takes time and costs money, and in some states it can take years. I walk through that in what happens when a borrower defaults.

Yield and term

Private real estate debt generally pays more than Treasuries and investment-grade bonds. That extra yield isn't free. It's payment for giving up liquidity, taking on borrower and collateral risk, and investing in a market with less regulation and less transparency than public bonds.

Term matters too. Long bonds carry the most duration risk. Many real estate loans are short to mid term. In our fund, investor certificates run 24 to 60 months, and many of the loans the fund originates are short-term loans, so capital turns over and can be redeployed at the rates available then. Shorter terms also cut both ways. If rates fall, new loans may pay less.

When bonds may be the better fit

Bonds do some things private debt can't. They may be the better choice if you:

• Need daily liquidity. You can sell a Treasury or a bond fund on any trading day.
• Want government backing. Treasuries are backed by the U.S. government. No private loan is.
• Are in a high tax bracket in a taxable account. Municipal bond interest is often federally tax-exempt, which can close much of the yield gap.
• Want very low costs. Index bond funds can cost a fraction of a percent a year.
• Value regulated public markets with standardized disclosure, ratings, and price transparency.
• Aren't accredited, or are investing smaller amounts. Bonds have no accreditation requirement.

Private real estate debt may fit better for money you can commit for a set term, when you want income set by loan contracts instead of a market price, and when you want to know what property sits behind each loan.

Questions to ask either way

• Who is the borrower, and what happens if they can't pay?
• Is the loan secured by specific collateral, or only by a promise?
• If rates rise, does my price move, my income move, or neither?
• How and when can I get my money out, and at what price?
• What are the total costs, and how is the income taxed in my account type? Ask your tax advisor.

Where Essential Income Fund I fits

Best for verified accredited investors who want a higher contractual rate than high-grade bonds typically pay, secured by real estate and paid monthly, and who won't need the money before the term ends. Not for your emergency fund, money that must stay liquid, or the part of a portfolio meant to hold steady when stocks fall. For those jobs, Treasuries, high-grade bond funds or insured deposits are the better choice. It's also not for anyone who isn't a verified accredited investor.

This article is for educational purposes only and is not investment, legal, or tax advice. It describes general characteristics of real estate debt investments; individual investments differ, and all involve risk, including the possible loss of principal. Essential Investment Group, LLC is not a registered investment advisor, broker-dealer, or bank. Any offer of securities in Essential Income Fund I, LLC is made only through its Private Placement Memorandum to verified accredited investors under Rule 506(c) of Regulation D.