How to manage bonds in a rising interest rate environment

1. 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.

2. Converts are less impacted in price than traditional bonds amid rising
interest 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 converts
assembled by SSI Investment Management, with key equity and bond
measures. When the stock market falls, converts don’t tend to drop as
much as their underlying shares. That’s reflected by the SSI portfolio’s
low (0.44) correlation with the Standard & Poor’s 500 stock index. The
convert portfolio’s correlation to the Barclays Long-Term Bond Index is
negative 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 traditional
market indexes, as well. Most REITs are landlords: They own
commercial buildings and generate earnings from rents, providing nice
dividend income for investors. According to the National Association of
Real Estate Investment Trusts, the yield averages 3.4%, higher than a
10-year Treasury and the S&P 500 (both around 2%).
Commercial buildings are vulnerable to economic downturns. They run
the risk of high vacancy rates, which happened during the Great
Recession. But REITs’ high payouts help cushion them. Since the
recession’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 years
since.
This REIT index has a fairly high correlation (0.74) to the Russell 3000
stock index, a broad-market benchmark like the S&P 500. But what’s
important to bond investors is that REITs’ equity-like characteristic gives
it 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 Capital
Group. These REITs, as the name suggests, do not trade on exchanges
like other property trusts.
Investing in them is a lot like buying a bond: The shares are redeemed at
a fixed price, often after 10 years. Meanwhile, you enjoy high dividends.
The downsides are that non-traded REITs are difficult to get out of before
their term elapses.
One way around this illiquidity is a new closed-end mutual fund that
invests in real estate private equity funds, called Versus Capital Multi-
Manager Real Estate Equity Income Fund (VCMRX). It trades like a
stock. The fund has stakes in blue chip organizations like UBS Global
Real Estate and J.P. Morgan Global Real Assets. With a minimum
investment of $10,000, the fund aims for a 5% to 5.5% dividend yield.
David Gratke is chief executive officer of Gratke Wealth LLC in
Beaverton, Ore.

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Topic:
Investing
Bonds
REITs