REITs have been rather defensive through 2019 as Asian equities battled with trade wars.
Most of us thought they were defensive enough that the price would not drop like a stone. Well, we were a little bit wrong.
Since 19 Feb 2020, the United States market has been spooked now that the people in the United States and Europe realize that Hey! This Corvid 19 Virus will have a big impact on us as well!
Europe and the United States have the sharpest 1-week fall in prices in its history for the past week.
- The S&P 500 went down -12%.
- For the month, the index hit a historical high and now it is down -9.6%.
- Monthly -10% returns, which 9.6% is closed to on the S&P 500 are rare. From 1926 to the end of 2019, there have only been 25 months out of 1,116 months where the monthly returns are less than -10%. That is 2.2% of the time.
On Friday morning, Asian equity markets finally gave in after days of not reacting to US market prices, giving up 3-4% in a day.
Within the volatility, I think there were two side lessons on REITs that we can learn about.
The first learning point is that from time to time, REITs can have a low correlation with equity price movements. However, they might not have the important downside protection properties that bonds have.
The second learning point is to debunk the narrative of how sensitive REIT returns are to interest rate changes.
What Does Correlation Mean
The unique thing about asset classes is that what belongs to an asset class should exhibit the same characteristics as one and another.
However, when we compare each asset in an asset class to another asset in another asset class, they should show different properties.
Cash, Properties, Stocks, and Bonds have low correlations with one another. This means that if stocks go down like this period, the value of cash, properties and bonds should not adjust in an equivalent manner.
We call these correlations. It should be pointed out that these correlations between assets change from time to time.
Usually, when markets get spooked, correlations of various assets become highly correlated (meaning they go down together).
We know that during this period, your cash in your bank account does not go down 12%. So your cash shows no correlations with the value change in equities.
The Performance of Bond ETFs During This Period
We often balanced up the equities in portfolio with bonds.
Traditionally, bonds and equities have low correlations.
The bond allocation is supposed to give the investor a positive expected return over time. However, the bonds portion traditionally have lower volatility than equities.
The lower volatility and low correlations to equities should act as a counterbalancing mechanism when equities go to shit.
I am going to show you the performance of different bond ETFs during this period that starts on the 19th of Feb. The majority of this ETF is listed on the United States and United Kingdom Stock Exchanges.
If you have a stock brokerage account (here is a beginner’s guide how you buy and sell ETF) that allows you to buy stocks on the UK stock exchange, you could get invested into these mainly Ireland domiciled ETFs. Some brokers are Standard Chartered Online Trading, DBS Vickers, Saxo, and Interactive Brokers.
iShares 20+ Year Treasury Bond ETF (TLT)
The TLT is listed in the United States stock exchange. Its index is the ICE U.S. Treasury 20+ Year Bond Index.
As we can see, the relationship with equities is the opposite during this period. The TLT is probably something a lot of people will shift money to when there are shocks like this (other than the other favorites such as gold, USD)
iShares Core Global Aggregate Bond UCITS ETF (AGGU)
The AGGU tracks the Bloomberg Barclays Global Aggregate Bond Index. 53% of the index is in the US Treasury. 12% is in mortgage-backed securities. 17% is in corporate bonds.
85% of the bonds are rated A and above. The rest are rated Baaa.
Prices during this period have not declined.
Nikko ABF Singapore Bond ETF
The ABF SG Bond ETF is a Singapore listed ETF that tracks iBoxx ABF Singapore Bond Index Total Return Series. 88% of the ETF is in the Government of Singapore bonds.
We observe that during this period, the bond ETF is holding up well as well.
iShares High Yield Corp Bond UCITS ETF (HYGU)
The HYGU tracks the Markit iBoxx Euro Liquid High Yield Index. It is a high yield ETF where the bonds are sub-investment grade (or known as junk bonds).
The top holdings is Italy (17%), USA (14%), France (13%), Germany (11%), Netherlands (8%).
The performance of HYGU during this period is highly correlated with the S&P 500 movement. The HYGU shows us that there are certain sub-asset class segments that leans towards other asset classes.
Junk bonds are issued by firms with greater risk and during distressed times in the equity markets, the same set of companies may be faced greater financial difficulty, thus the bonds faced greater probability of defaults. They are priced accordingly.
The Performance of S-REITs During This Period
The best proxy to assess the aggregated short term performance of the Singapore REIT market is the Lion-Phillip S-REIT ETF.
It is a market-weighted portfolio of Singapore REITs.
If we try to replace our bond allocation with REITs, then at least, we should wish that when there is a market fall, REITs should exhibit some low correlations.
The S-REIT ETF is down 8.4% during this period. The magnitude of the fall is lesser but it does show a pretty high correlation with the general markets.
The chart above shows the Vanguard Real Estate ETF for the United States. It too shows the same weakness as the S-REIT ETF. The magnitude of the drawdown is similar to the S&P 500 during the same period.
There are a few explanations of why this occurs. From the people I spoke to, they say a mixture of:
- Passive ETF Selling
- Active funds selling for redemptions and closet indexing
So there is little fundamentals going into the selling (for now).
The importance of reviewing the bond ETF performance against the REIT ETF performance is to calibrate investors expectations of REITs:
- At times when the stock market is up, the REITs might or might not go up together
- At times when the stock market is down, the REITs might or might not go down together
- In times of panic, when the stock market goes down, highly likely the REITs will increase the correlation with stocks and go down together
In a way, REITs are very dependent on leverage and relatively high yield. Thus, they exhibit a lot of similar characteristics as junk bonds.
If the reason you have REITs in your portfolio is to reduce the volatility of the portfolio, that might work in a normal situation (absence of market panic, prolong recession) then having REITs does help.
We have seen in situations where the performance of REITs deviates from different regional stock markets. If you have a mixture of bonds, REITs, and stocks, they go up and down at different times. Thus, the volatility might be smoothed out.
But if you expect the low correlation with equities during times like this, then perhaps your confidence is misplaced.
The Correlation with Interest Rate Movement
During this period, we can also observe evidence that disprove REIT’s performance is highly correlated to interest rate movement.
In my Learning to Invest in REIT section of my blog, I have provided two articles that help explain interest rate movement and its relationship to REITs:
REITs borrow a significant amount of debts on their balance sheet and thus interest rate movement affect them from time to time:
- When the market interest rate changes, it affects the cost the REITs have to borrow to re-finance existing debts or finance new property purchases. Lower market interest rates are generally conducive for REITs while higher market interest rates make it challenging for them.
- Since there is a bunch of investors that treat REITs like a bond replacement, if the market interest rate goes up, they can easily switch to invest in higher-yielding debt at lower risk than REITs. So REITs prices would have to be adjusted down so that they provide a higher, more competitive yield relative to the lower risk debt. Vice-versa
During this period (may not entirely be due to the Corvid-19 virus situation), we observe that the 10-year Government Bond Yields for countries have been going down.
The cost of borrowing for REITs tend to be priced in relation to the long-dated government bond rates. Thus, observing the yield changes gives us an indication of the cost of re-finance or borrowing for the REITs.
Here is the Australia 10-Year. While the past year trend is down, notice the acceleration since the turn of the year, and the steep drop since Feb 19.
Here is the US 10-Year Bond Yield. The yield collapsed by nearly 40%.
And finally here is the Singapore one.
In 2019, when the yields came down, it makes REITs look particularly attractive. Their borrowing cost is lower and their ability to purchase more properties improves. They are also seen as better yielding prospects versus the lower risk or similar risk bonds.
Now that we are in an interesting situation that the rates moved even lower. This should be more conducive to the REITs. Yet, the reality is that the prices do not show that.
We all can be rather forgetful about events like this once it passes and things went back to normal. So I wish to take this opportunity to note down a period where we can learn from.
I think interest rates have a profound impact on REITs, but that is not the only factor.
And this is how you should look at REITs. Their performance is dependent on a few factors as well, interest rates aside (Read The 3 Main Considerations when Picking REITs). To base your decision purely on the interest rate and its relation to REIT can be a bit myopic.
There are reasons why bonds and cash are still very popular when we structure our overall portfolio. They may be low yielding, but you should expect the returns to be positive in the long run.
Its main role is for us to create a portfolio mix that blends well with your risk tolerance.
I have received many feedbacks about people forming a portfolio with REITs and stocks thinking REITs have all the properties of bonds and some upside of stocks.
If they have such similar properties as bonds, we can plan for an investor a moderate portfolio made up of 50% equities and 50% REITs. The expectation is that if the general equity goes down by 50%, the portfolio goes down by maybe close to 25% to 35%.
For an investor who can only take a moderate level of risk, this is more livable and they can stay invested better.
However, if the REITs do not have a low correlation with equity like the bonds do during a prolong bear, the investor could see their portfolio down 50%.
The best way is just to accept that REITs are a segment closer in relation to property-related stocks. They are more related to property cycles but also am affected as equities.
You can check out some of my serious write-ups talking about REITs in Learning about REITs below.
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Sunday 1st of March 2020
Hi Kyith, thanks for this interesting perspective. I think it's still a bit early to tell the true extent of correlation between REITs and other equities. It's only been a week since global markets really began reacting to the virus and we've yet to observe a bottom or a stabilising of prices, so all this selling could well just be a knee-jerk reaction by fund managers or algorithms. You are probably right that fundamentals have not been fully priced in; I think once prices stabilise we will see rationality dethrone fear as the main driver, and then we can make conclusions. The threat posed by the virus is also unlike a "normal" trade-induced panic, because the situation develops so rapidly. If a cure is suddenly found or if we see signs of containment, sentiment could change within a matter of days.
Thursday 5th of March 2020
that is right. you could see maybe i spoke too soon judging by the recent reit performances