This article was originally featured on Morningstar.com, The Online Investor,National Real Estate Investor and two others April 23, 2012. Escaping Higher Bond Rates Submitted by David Gratke on Mon, 04/23/2012 - 12:00pm Bondholders are dreading the inevitable rise in interest rates. When rates rise, bonds generally lose value. But there are alternatives for fixed-income investors that won’t suffer, or at least not as much: real estate investment trusts (REITs) and convertible bonds. With interest rates at historic multi-decade lows, investors can no longer turn to bonds to reduce risk. After a three-decade decline, rates will rise sooner or later. Now, $9 trillion dollars is in the global economy from central bank “printing” that was not there five years ago. Historically, bond managers used shorter maturity bonds to manage interest rate risk. This allows them to capture the principal back sooner, for re-investment at higher rates during rising interest rate environments. Plus, when rates rise, shorter-term bonds do not depreciate in value as much as long-term bonds. This strategy is not as viable as it once was, however, because rates for almost all bonds are so low: The benchmark 10-year Treasury yields around 2%. Convertibles and REITS, both publicly and non-publicly traded, have low or negative correlations to stocks and other bonds. Correlations tracks the way two assets relate to each other. A correlation of 1.0 means the two assets rise and fall exactly alike. The lower the correlation, the less they move together. A negative correlation means they move opposite one another. Convertible bonds. These bonds can be switched into a fixed number of a company’s common shares. The conversion takes place when the common has risen to a certain price. While you are waiting, you collect bond interest, although usually not as much as the company’s regular bonds pay.
Converts are less impacted in price than traditional bonds amid risinginterest rates.Reason: If the bond market is falling apart, people may rush into stocks,giving convert owners a potentially lucrative escape option.Compare the SSI Convertible Income Strategy, a portfolio of convertsassembled by SSI Investment Management, with key equity and bondmeasures. When the stock market falls, converts don’t tend to drop asmuch as their underlying shares. That’s reflected by the SSI portfolio’slow (0.44) correlation with the Standard & Poor’s 500 stock index. Theconvert portfolio’s correlation to the Barclays Long-Term Bond Index isnegative 0.06. Plus, its objective is a dividend return of 6% to 7%.(Minimum investment: $1,000.)REITs. Real estate has typically displayed low correlations to traditionalmarket indexes, as well. Most REITs are landlords: They owncommercial buildings and generate earnings from rents, providing nicedividend income for investors. According to the National Association ofReal Estate Investment Trusts, the yield averages 3.4%, higher than a10-year Treasury and the S&P 500 (both around 2%).Commercial buildings are vulnerable to economic downturns. They runthe risk of high vacancy rates, which happened during the GreatRecession. But REITs’ high payouts help cushion them. Since therecession’s end, vacancies have fallen. In 2008, the FTSE-NAREIT All-REIT Index fell as far as the S&P 500, but has outstripped it in the yearssince.This REIT index has a fairly high correlation (0.74) to the Russell 3000stock index, a broad-market benchmark like the S&P 500. But what’simportant to bond investors is that REITs’ equity-like characteristic givesit a negative correlation of 0.11 to the widely referenced bond index,Barclays Aggregate Bond Index.Non-listed REITs are even less correlated to stocks (0.17) and bonds(negative 0.08) over the past 15 years, according to Versus CapitalGroup. These REITs, as the name suggests, do not trade on exchangeslike other property trusts.Investing in them is a lot like buying a bond: The shares are redeemed ata fixed price, often after 10 years. Meanwhile, you enjoy high dividends.The downsides are that non-traded REITs are difficult to get out of beforetheir term elapses.One way around this illiquidity is a new closed-end mutual fund thatinvests in real estate private equity funds, called Versus Capital Multi-Manager Real Estate Equity Income Fund (VCMRX). It trades like astock. The fund has stakes in blue chip organizations like UBS GlobalReal Estate and J.P. Morgan Global Real Assets. With a minimuminvestment of $10,000, the fund aims for a 5% to 5.5% dividend yield.David Gratke is chief executive officer of Gratke Wealth LLC inBeaverton, Ore.
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