REITs versus Junk Bonds: Taking a Closer Look at the Spreads

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 |  Includes: AGG, REZ, TIP, VNQ
by: James Picerno

Volatility has returned to the capital markets and that's good news for strategic-minded investors. Higher volatility is usually associated with lower prices, which in turn can generate more favorable valuations. Deciding when the valuations look sufficiently tempting, however, is never easy.

Consider two asset classes that have been under pressure of late: REITs and high-yield bonds. Of the two, REITs have been hit harder. For the year through the end of last month, REITs suffered a 2.5% loss, based on the Vanguard REIT ETF (NYSEARCA:VNQ). High yield bonds fared better by posting a 3.6% rise YTD through October, as per Vanguard High Yield Corporate (MUTF:VWEHX). Even so, junk took a heavy blow in the July/August correction, and since then has only recovered a portion of its former glory.

Both asset classes are distinctive for their yields. By that standard, the price declines in each have brought higher yields. (As always, price and yield move inversely for bonds and equities.) Are the yields tempting?

Unfortunately, there's no easy answer. If you look at a 20-year history of yields, almost nothing looks compelling today. Then again, we're told that inflation is contained and will no longer threaten. If you believe that, then maybe lower yields look okay after all. But then one might ask: Do I believe the inflation-is-history story?

On and on it goes. If you wait for definitive proof, you'll be sitting in 100% cash forever, which is hardly an enlightened strategy. As such, some degree of risk is necessary for every portfolio. But how much? And do REITs and junk now fit the bill for redeploying cash?

In search of clues, let's start by looking at the trailing annual yields for each. As our chart below shows, yields have recently popped up although no one should confuse the trend with a massive buy signal. U.S. REITs, for instance, recently offered a yield that's only slightly higher than the levels of late-2006/early-2007, when the REIT bull market was still riding high. As for junk bonds, yields are higher and the jump in payout in recent months has been stronger.

But how do the yields compare with the benchmark 10-year Treasury? In fact, the FTSE NAREIT US REIT Index (NYSEARCA:REZ) closed out last month at a yield of just 4.17%, which was slightly below the 10-year Treasury yield, as our second chart below illustrates. Junk bonds look more encouraging now that the spread over the 10-year rose above 400 basis points as of last month's close.

In the long run, it's all about spreads for yield-sensitive securities. To be precise, how much yield does a security or asset class offer over the risk-free rate? It's an iron law of finance that there's no reward without risk. At the same time, investors should ask for sufficient compensation for embracing risk. For REITs, recent history suggests that 200 basis points over the 10-year is a reasonable standard at which to at least start looking closer at the asset class. Alas, we're still well below that risk premium.

For high yield bonds, recent experience tells us that a risk premium above 400 basis points looks relatively intriguing. As such, we're more encouraged that value's returning to junk bonds. The wider the spread above 400 basis points, the more enticing junk looks, in which case it may be deserving of a higher weight for long-term-oriented portfolios. For now, the asset class is worth a nibble but nothing more. REIT yields, by contrast, still have a long ride upward before the asset class looks compelling.

Of course, none of this means that's junk's a sure winner from here on out, or that REIT prices won't soar. We can't see the future but we can at least read the fine print, and decide if risk premiums look attractive. Do they? Not really, but as this year reminds, nothing ever stays the same in finance, and so we're still cautious but hopeful.