Contrarian Update: Time for Bonds and REITs

There's a bear market in prices, but the bull is alive and kicking when measured in risk premia, albeit in varying degrees, depending on the asset class.

Consider two examples in our chart below, which illustrates the history of yield premia for high yield bonds and equity REITs relative to the 10-year Treasury yield. Clearly, Mr. Market is offering a bigger cushion of safety in these asset classes relative to recent history. The question is whether the cushions will suffice for what's coming? To be sure, higher yield premia are no shortcut to easy profits, but neither are they chopped liver.

For junk bonds, the premium over the 10-year is the highest in five years. At the end of August, the Citigroup High Yield Index posted a trailing yield of 779 basis points over the constant 10-year Treasury yield, as per numbers from the St. Louis Fed. That's the richest spread for the index since early 2003.

The spread premium on equity REIT yields, although higher relative to recent history, is less compelling. At 115 basis points over the 10-year yield, the NAREIT trailing yield has risen from negative territory, but it still pales in comparison to the 300-basis-points plus of 2003.

What does it all mean? The case for buying junk and REITs looks more enticing today than it did in 2006 or 2007. That doesn't mean you can't lose money in either asset class going forward, but it does suggest that the prospective returns vary and that's largely driven by shifting valuations.

For investors with broadly diversified portfolios across the major asset classes and a long-term focus of five years or more, the above charts suggest that it's time to start nibbling at high yields bonds via broadly diversified portfolios targeting the asset class. The same could be said for REITs, although the case is less compelling.

Putting cash to work these days is unnerving, of course, as yesterday's steep decline in the stock market reminds. But blood is running and that suggests that prospective returns are higher. No guarantees, of course. Even prudent-minded investment strategies can look ugly in the short run, and perhaps for even longer stretches than logic suggests. That said, opportunity abounds, at least for those who have risk capital at the ready and the stomach for the roller coaster that almost certainly awaits in the near term.

Comments

[Larry House:]

Thanks, James. There is not enough written about bonds, but with equities on a roller coaster (bonds are too for that matter), bonds are more interesting. I have started nibbling at HY bonds with HIX, a CEF yielding over 12%. To diversify, I also hold ACG, CHY, and FAX. These certainly fluctuate in price, but I think the yields are reasonable. The four CEFs combine to yield 10% as a group. I don't know of any sure thing in this investment climate, and bonds are not one either, but I think they are worth holding.

2008 Sep 10 10:58 AM

[Jay:]

can we also think through the absolute level of yields? if one believes a rise in the 10-year yield is on the horizon, even a mild tightening in these spreads doesn't bode well for expected returns.

2008 Sep 10 11:59 AM

[knight722:]

"Clearly, Mr. Market is offering a bigger cushion of safety in these asset classes relative to recent history."

I'm not sure any reference to "recent history" gets the job done. Recent history includes a monetary policy of easy credit and the repricing of all equity issues by virtue of the adventures of LBO sharks. REITs in particular may live in a much different world.

2008 Sep 10 06:56 PM