Category Archives: Bonds

Goldman Sachs Predicts 4.5% 10-year Treasury Yields

Treasury BondGoldman Sachs just came out with a prediction that 10-year Treasury bond yields will rise to 4.5% by 2018 and the S&P 500 will provide 6% annualized returns over that same period.  The driver for this prediction is simply that the Fed is expected to raise the federal funds rate.

Because rising yields correspond to falling prices for bonds, Goldman’s forecast is that equities will substantially outperform bonds over the next several years.  If you are holding a bond yielding 2.5% (the current 10-year Treasury yield) and the Fed raises rates, investors will sell off their holdings of lower-yielding bonds in order to purchase newly-issued higher-yielding bonds.  If Goldman’s forecast plays out, bondholders will suffer over the next several years, while equity investors will enjoy modest gains.

Historical Perspective

This very long-term history of bond yield vs. the dividend yield on the S&P 500 is worth considering in parsing Goldman’s predictions.

Bond Yield vs. Dividend Yield

Source: The Big Picture blog

Prior to the mid 1950’s, the conventional wisdom (according to market guru Peter Bernstein) was that equities should have a dividend yield higher than the yield from bonds because equities were riskier.  From 1958 to 2008, however, the 10-year bond yield was higher than the S&P 500 dividend yield by an average of 3.7%.

Then in 2008, the 10-year Treasury bond yield fell below the S&P 500 dividend yield for the first time in 50 years.  Today, the yield from the S&P 500 is 1.8% and the 10-year Treasury bond yields 2.5%, so we have returned to the conditions that have prevailed for the last half a century. But the spread between bond yield and dividend yields remains very low by historical standards.  If the 10-year Treasury yield increases to 4.5% (as Goldman predicts), we will have a spread that is more consistent with recent decades.

Investors are likely to compare bond yields and dividend yields, with the understanding that bond prices are extremely negatively impacted by inflation (with the result that yields rise with inflation because yield increases as bond prices fall), while dividends can increase with inflation.  During the 1970’s, Treasury bond yields shot up in response to inflation. Companies can increase the prices that they charge for their products in response to inflation, which allows the dividends to increase in response to higher prices across the economy.  The huge spread between dividend yield and bond yield in the late 70’s and early 80’s reflects investors’ rational preference for dividends in a high-inflation environment.

What Has to Happen for Goldman’s Outlook to Play Out?

To end up with a 4.5% 10-year Treasury yield with something like a 2% S&P 500 dividend yield, the U.S. will need to see a sustained economic recovery and evidence of higher prices (inflation) driven by higher employment and wage growth.  In such an environment, investors will be willing to accept the lower dividend yield from equities because dividends grow over time and tend to rise with inflation.  This has been the prevailing state of the U.S. economy over the last fifty years.  Most recently, we had 10-year Treasury yields in the 4%-5% range in the mid 2000’s.  If, however, we continue to see low inflation and stagnant wages in the U.S. economy, bond yields are likely to remain low for longer.

REITs and the Rally of 2014

There have been a number of surprises for investors in 2014.  Bonds have markedly out-performed stocks for the year-to-date.  The S&P500 is up 2.4% since the start of 2014, as compared to the Barclays Aggregate Bond Index, which is up by 3.5%.  Even more striking, the iShares 20+ Year Treasury Bond ETF (TLT) is up by 12.5% YTD and the Vanguard Long-Term Bond fund (VBLTX) is up by 11.4% YTD.  Interestingly, REITs have been also experienced a substantial run-up in 2014 so far.  The Vanguard REIT Index fund (VGSIX) is up 16.1% YTD and the iShares U.S. Real Estate ETF (IYR) is up by 14.4% YTD.

To understand the rally in REITs, it is useful to start with an overview of this asset class.  REITs are neither stock (equity) nor bond (fixed income).  A REIT uses investor money, combined with borrowed money, to acquire real estate.  The properties that they acquire can be office buildings (BXP, SLG), apartment buildings (EQR, UDR), healthcare facilities (HCP, HCN), or even digital data centers (DLR).  The returns vary between the specific types of property owned.  REITs make money from renting their facilities out.  Please note that I am discussing only equity REITs (those which own property).  There is a secondary form of REITs that buy baskets of mortgages.  These are called mortgage REITS (mREITs).

REITs are classified as ‘pass-through’ or ‘flow-through’ entities and pass at least 90% of their taxable income to their shareholders each year.  For this reason, REITs are often favored by income-oriented investors.

REITs have their own unique measures of value and drivers of performance.  Rather than price-to-earnings ratio, a measure of the valuation of stocks, the preferred measure of valuation for REITs is price-to-funds from operations (FFO).  A notable feature of REITs is their exposure to interest rates.  In general, stocks go up when interest rates rise, while bonds fall.  When interest rates decline, the reverse tend to be true: stocks decline and bonds rise in value.  REITs tend to have a fairly neutral response to changes in interest rates, although this varies.  To the extent to which REITs need to borrow in the future due to rolling credit or new financing, their costs rise when interest rates rise.  REITs often also have the ability to raise rents, however, so that their revenue can also rise when the costs of residential or commercial real estate rise with inflation.  In addition, because REITs own a physical asset (property), the value of the assets owned by the REIT tend to go up with inflation.

An examination of the performance statistics of REIT funds illustrates their properties quite clearly.

Chart 1

REIT funds vs. major asset classes (10 years through April 2014)—Source: Author’s calculations

The returns above are the arithmetic average of returns over the past ten years, including reinvested dividends.  Beta measures the degree to which an asset tends to amplify or mute swings in the S&P500.  The betas for VGSIX and IYR show that these funds tend to rise 1.3% for every 1% rise in the S&P500 (and vice versa).  These broad REIT funds tend to do well in rising stock markets and will also tend to perform worse than the S&P500 when the market crashes.  The S&P500 fell 36.8% in 2008, for example, and IYR fell 39.9%, for example.  The high beta is only one factor that determines the returns from these REIT index funds, however.  Despite a massive decline in real estate in 2008, the average annual return for these two REIT funds has been very high over the past ten years.  The volatility levels exhibited by these REIT funds is, however, very close to that of emerging market stocks, as shown above.

The best way to understand the unique features of REITs is to look at the correlations in the returns between asset classes, bond yields, and the returns from a traditional 60/40 portfolio (60% stocks, 40% bonds).

Chart 2

Correlations between monthly returns over the past ten years (through April 2014) for major asset classes, 10-year Treasury bond yield, and the returns from a 60/40 portfolio—Source: Author’s calculations

Equity indexes tend to have positive correlations to Treasury bond yields (because yield goes up when bond prices go down, and vice versa).  This effect is evident in the table above.  S&P500 stocks (represented by SPY) have a +30% correlation to the 10-year Treasury yield.  The same relationships hold for the other major equity classes in the table above (EFA, EEM, QQQ, and IWM), with correlations to the 10-year Treasury yield ranging from 20% (EFA) to 36% (IWM).  In 2013, Treasury bond yields rose and stock indexes gained substantially.  By contrast, the returns of bond funds (AGG, TLT) are negatively correlated to the 10-year Treasury bond yield.  The returns from these funds tend to be positive when Treasury yields are falling and vice versa.

Treasury bond yields follow interest rates and inflation.  When rates or inflation rise, bond yields rise because investors sell Treasury bonds to avoid getting caught with relatively low-yield bonds in a higher rate environment.  The selling continues until the yield on the bonds is in line with new rates.  This is why returns on the two bond funds are so negative correlated to Treasury yield.  When yields go up, bond prices fall and vice versa.

VGSIX and IYR have 6% and 7% correlations to the 10-year Treasury yield—which means that these REIT funds are not highly sensitive to movements in bond yields.  While investors were betting on rising yield in 2013, opinion seems to have shifted in 2014.  If you are looking for asset classes that don’t require a bet on whether interest rates will go up or down, REITs look pretty attractive.

The correlations between the returns from each asset class and the returns from a 60% stock / 40% bond portfolio show the degree to which adding these asset classes to a simple stock-bond mix is likely to provide diversification benefits.  The higher the correlation, the less diversification benefit you can expect.  The key idea in diversifying a portfolio is to combine assets with low correlations so that when one is losing money, others are likely to be doing something different (hopefully rising in value).  As compared to the major equity asset classes, the REIT funds have a lower correlation to the 60/40 portfolio.  This, in turn, suggests that REITs can provide more diversification benefit than equities to a portfolio that currently holds stocks and bonds.

In summary, the basic narrative to explain the rally in REITs goes something like this.  REITs provide substantial income compared to bonds and equities, as well as being essentially interest rate neutral.  While REITs are a volatile asset class, the relatively low correlation between REITs and equities provides diversification benefit to a portfolio of domestic stocks and bonds, as well as providing some modest protection from rising interest rates.  REITs appear have come back into favor after being sold off during and after the so-called taper tantrum of 2013, with yield-hungry investors leading the charge.  In a slow-growth environment, with the Fed indicating that they foresee an extended period of low rates, REITs look quite attractive.  The caveat to the positive view on maintaining an allocation in REITs is that there are substantial differences between the yield, risk, and interest rate exposure and that REITs have historically been a volatile asset class.  Unless you firmly believe that you can outsmart the broader market, REITs should be thought of as a long-term income producer and diversifier.  For those investors who have maintained a strategic allocation to REITs, the gains in 2014 YTD have helped to bolster portfolio returns as equities have provided very little to investors beyond their dividends.  The downside to this positive narrative, however, is that increased prices for REITs translate to lower yields for today’s buyers.

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A ‘New Era’ for Bonds?

The Wall Street Journal recently published an article titled How You Can Survive a New Era in the Bond Market.  The article suggests that investors adjust their bond allocations to tilt more towards high-yield (aka junk) bonds (both corporate and municipal) and global bonds, which tend to yield more than U.S. bonds.  This advice resonates with an Op Ed by Burton Malkiel, famed author of A Random Walk Down Wall Street, at the end of 2013.

The case against bonds is straightforward.  The best estimate for the expected future return from bonds is their current yield.  If you hold a bond until maturity, your total return will be very close to the current yield.  There are nuances to this rule.  With high-yield bonds, you should expect a total return that is a bit less than the current yield due to the fact that some of these bonds will probably end in default.  With bond funds, you don’t necessarily end up holding individual bonds until maturity, so the correspondence between current yield and expected return is a bit weaker.  Nonetheless, with current yields as low as they are, bond investors should not expect attractive returns from most bond classes.

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With the U.S. government failing to reach agreement on budgetary issues and on raising the debt ceiling, there is considerable discussion of what this would really mean.  From what I have read, the issues are quite straightforward.  If the U.S. government does not raise the debt ceiling, the Treasury will not have sufficient funds available to meet all of its obligations, starting sometime in mid-October.  For the time being, many government workers have been furloughed and services suspended.  Continue reading

REIT Yield as a Predictor of Future Returns

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The Great Rotation?

The financial media loves a catch phrase and, with the apparent emotional hook of the ‘fiscal cliff’ diminished, we needed a new one.  The current best candidate is the so-called ‘Great Rotation.’  The idea here is that investors, finally and completely fed up with the dismal returns from bonds, are going to move heavily back into equities.  This is the ‘Great Rotation.’  When I Google the term, there are 820,000 search results.  Not bad for a phrase that was invented in October 2012 (in a research note from Bank of America, apparently).  Continue reading