Low Rates, Low Growth, REITs & Bonds During a Recession

Here is a sample of the questions that were discussed In this week’s PensionCraft live Q and A call with Ramin. If you want to find out the full answers to these questions or ask some for yourself, then you can subscribe on Patreon here

The full set of notes and video replay are available for Patreon supporters here

What are the advantages and disadvantages of investing in Real Estate Investment Trusts (REITs)?

Do REITs behave in a cyclical manner and where do they sit in the correlation dendrogram and in the economic cycle?

REITs are attractive because they offer a tax-efficient way of receiving income from property.

A company with REIT status isn’t subject to corporation tax. In return, HMRC demands that REITs distribute at least 90% of their property income to shareholders every year as property income distribution (PID) dividends. The REIT must withhold basic rate income tax of 20% on these payments. If the REIT rules didn’t exist, investors would suffer double tax: once because the company would pay corporation tax and twice because you’d then pay tax on the dividends. 

Yields for REITs will fall as yields for other assets fall. They have the same indicators as global equity and are like higher beta versions of equity.

REITs are potentially more rate sensitive given their role in a portfolio as income generators and are often leveraged investments so funding costs are an issue but the correlation to rates changes over time. The period of negative responses is significant because it contributed to REIT underperformance relative to the S&P 500 and other broad market aggregates during the past few years. That’s why the Fed’s comments that their target for short-term interest rates will remain around current levels, and the return to a positive relationship between REITs and interest rates, is favorable for REIT investors.”

When the Fed tightens policy (raises interest rates) the correlation between 10 year Treasury yield and REIT returns goes negative.

In April 2019 PensionCraft said, “At the moment it’s turned positive again so this is good for REITs if yields don’t fall sharply”. Well… now Fed policy is to lower rates and yields are falling.

If you intend to invest in REITs you need to be aware that …..

Would bonds still be a good investment If there is a recession in 2019/2020?

During a recession, yields fall because investors move their money out of risky assets (equities) into safe-haven assets (bonds). The question is really whether that remains true even in an environment when yields are low or negative.

As we’ve seen there is no proper alternative to bonds. The income on government bonds with some duration will (almost) always be more than the income on cash. The reason for this is duration risk.So why would investors accept a lower return on bonds of short duration (low but non-zero risk) than they’d get for cash (almost zero risk, government guarantee and zero volatility).  You would never buy an asset with higher risk and lower returns, particularly in the fixed income world where risk and return are so clearly linked.

If cash returns were higher than bond returns, very few investors would buy bonds, bond prices would fall and yields would rise until they are higher than cash interest rates. However don’t buy developed market bonds for capital appreciation, buy them for capital protection & diversification for your shares.  When equities fall 50% you’ll be glad of the bonds in your portfolio and that’s why Vanguard calls them ballast.

Ballast is material that is used to provide stability to a vehicle or structure. Ballast, other than cargo, may be placed in a vehicle, often a ship or the gondola of a balloon or airship, to provide stability.

Has there been a time with both low interest rates and very low growth, what was the impact on asset classes and are there any lessons that can be learnt?

Although there is no precedent, as we have never been at a time where rates and yields have been this low,  there is still a lot we can learn from past trends and use this to influence our current investment strategy. 

We do know is that low growth means low long-term yield (assuming inflation is low too i.e. not stagflation). Low growth also  means corporate earnings growth is weak, therefore equity capital appreciation is weak as well. We also know that growth will not be low everywhere and there will be a premium for growth. For example, companies that generate revenues in emerging markets manage to grow their earnings but this also brings risk.

October 10, 2019