Hedging Bond Risk With REITs

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Includes: AMT, IYR, NLY, WPC
by: Michael D. Harris
Summary

Certain metrics and economic events are showing potential risk in the credit markets in a time where investors are likely rotating away from stocks into bonds.

With the uncertainty of the direction of interest rates by the Federal Reserve investors need to hedge potential declines in bond yields with an asset other than normal stocks.

I suggest REITs since they benefit from decreases in interest rates (opposite of normal bonds) and offer comparable yields to bonds.

I put forth three separate strategies for investors that use REITs to hedge bond risks.

Estimated read time: 8 minutes 55 seconds

Abstract

This article will go over the potential risk in credit markets and a potential solution to hedging that risk using one of three possible strategies involving real estate investment trusts (REITs) that I’m putting forward. The strategies vary in usefulness depending on the type of investor. Two of the strategies are geared toward individual retail investors or small wealth managers, while the third is geared towards hedge funds.

Intro

Percentage share of bearish investor sentiment from Bloomberg (Source: Bloomberg and the American Association of Individual Investors)

2018 ended with the worst full-year performance in stocks since the recession in 2008. We’ve seen the return of the bears, though most were premature in coming out of hibernation. With uneasy and anxious investors likely looking for safer, less turbulent returns over the next couple of years, the rotation into bonds is on its way. Unfortunately, the usual safe haven of bonds (both ones issued by private corporations and even ones issued by sovereign countries) are now coupled with a new added risk. Because of the added risk, I’m suggesting using REITs to hedge some of the risks. Some of you will immediately see a potential problem using real estate to hedge credit risk but if you read all the way through I lay out why I’m proposing hedging strategies involving REITs.

Corporate Debt Worries

There’s been a flurry of well-respected voices coming out recently to warn investors of potential risks in the credit markets. So far, the warnings have not come to fruition and the risks (if true) have stayed dormant. One of those voices is Dr. Edward Altman, creator of the Altman Z-score which is a scoring method used to determine credit and bankruptcy risk for a company. In an interview with tech entrepreneur turned hedge fund manager, Erik Townsend, in his podcast, Macro Voices, Altman, now a professor at NYU Stern School of Business, explained how the percentage of non-financial corporate debt (NFCD) to U.S. gross domestic product (GDP) is at an all-time high. This in itself doesn’t constitute doubt in private debt in the U.S., but due to its long-term cyclical nature and my own independent modeling analysis, it’s very likely that the current percentage rate of NFCD to GDP of 46.44% will revert back toward its historical average of 41.85%. In absolute terms, a move of less than 500 basis points doesn’t seem like a big move but, as you can see by the chart below, after peaks in the rate of NFCD to GDP, a following increase in the default rate occurs. This makes sense since the decline in the rate of NFCD to GDP likely occurs as the debt market reaches and passes its capacity and companies who borrowed too much are exposed during defaults. With a rise in defaults likely to occur sooner rather than later, buying into U.S. non-financial corporate bonds (especially junk-rated) has an extra degree of added risk that investors have to look at.

NFCD to GDP and 4-Quarter MA of U.S. Corporate Default Rate (Source: Dr. Altman slide deck from interview with Erik Townsend. Dotted black line is the historical average rate of NFCD to GDP.)

Bonus: at the end I've attached a PDF document where you can read the transcript of the full interview with Dr. Altman where he explains the situation in much better detail than I do.

Public Debt Worries

So, what about public issued debt? Well, besides the ongoing worries about the international effects of Trump’s trade war and isolationist stance that has caused investors anxiety since early 2018, there seems to be a fervor of unhappy populations calling for a change in the economic structure of their respective countries. Following Britain's decision (and on-going battle) to leave the European Union we've seen increased nationalistic movements with Trump in the U.S., Italy's new populist government, and now France's "yellow vest" protests. There seems to be an underlying issue that’s connecting these problems. Workers, especially in the lower-middle class (the “blue collar” workers) feel that they have been skipped over during this past decade of economic recovery. All of these seemingly isolated events are connected by this issue and until some sort of true, productive public discussion is had, more protests and uprise will happen. Because of this psychological shift in the public populations of countries, there is an undeniable factor of instability brought into the conversation. With the economic picture consumed by nationalism and trade wars and the public political debate heated with feelings of animosity towards the rich, markets and economies are at risk of serious change. Magnifying that risk is the fact that in this ever-growing world of international connectedness, if one country suffers, the ripples of that event rarely stay within the borders of that nation (take 2008 as an example).

Of course, there’s always the good old fashioned U.S. Treasury bond, the measure of “risk-free” for many quantitative finance models. With investors rotating into safety, the U.S. T-bills are one of the first places they’ve turned to in the past. So, why is now any different? Well, currently the Fed is undergoing the latter stages of the most substantial experiment in central banking history. After completing the quantitative easing phase, the Fed will now try to shed almost $2.5 trillion in assets over the coming years. That’s a near fifty percent reduction of the current balance sheet.

Total Federal Reserve Assets (Source: Federal Reserve of St. Louis FRED Tool)

This matters to investors looking for safe, high-rated bonds because the Fed usually only operates in the high credit-rating debt markets of U.S. Treasuries or super high-rated corporates, meaning that the safest of the debt markets will have an extraordinarily large player artificially moving the markets which will make it harder for retail investors and smaller firms to get in on the bond buying at prices they can tolerate.

Should we panic?

With corporate debt at all-time highs, a likely increase in U.S. corporate debt defaults, rumblings in sovereign economies, and the Fed attempting a soft-landing of rolling off $2.5 trillion in assets off its balance sheet, investors are understandably uneasy, but is the sky falling? Probably not, and if it were you wouldn’t be hearing about it here first. Still, now is definitely the time to start getting your ducks in a row to ensure that if something does go down then you’re still left holding some of the cards.

Before we go any further let’s round-up what we’ve discussed so far:

  • We’re in the later stages of the longest bull run in stocks in U.S. history
  • Investors are going to rotate into overweight positions in bonds to prepare for and protect against the expected bear market coming
  • Non-financial corporate debt is at an all-time high, which again is not a troubling sign on its own, but the debt cycle is cyclical and we’ll probably revert back to the mean in the rate of NFCD to GDP, which is always followed by a rise in defaults.
  • Populations all over the world are demanding nationalistic change that will disrupt global economies
  • The two largest economies on the planet are playing a dangerous game of four-dimensional chicken that could drastically affect the global economy
  • The Federal Reserve is now undergoing an experiment never done before in human history with quantitative tightening. No one really knows exactly how this will turn out regardless of how great forecasting models are for it.

Obviously, this paints a fairly bleak picture that should (and does) scare investors about what we’ll have to face in the immediate future. All of these reasons on their own are justifiably worth considering when deciding what investments to add or remove from your portfolio, but the fact that they’re happening all together is even more serious.

Again, the sky is not falling but there are some cracks that, if not fixed soon could turn into something detrimental. So then, what should investors do about it? Well, before I venture down that road and try to give you an answer, there’s one more factor to discuss that forms the foundation of the hedging strategies that I'm about to offer and that is, of course, Trump.

The Central Thesis

Many of you reading this are already aware (but if you're not then read this Bloomberg article that sums up the situation) that in December the sitting president of the United States had reportedly threatened and consulted with his advisors about the issue of removing the sitting Fed Chairman, Jerome Powell, if the Fed continues to raise rates. Luckily, the creators of the U.S. central banking system understood the dangers of letting the president push around the central bank and created a system where the Fed would be out of reach (for the most part) from the President.

Still, even if the President can’t remove the chairman without cause (which is arbitrary and leaves itself to different interpretations), he can put pressure on Powell, especially if the meeting between the two that is rumored to happen actually does take place. This puts Powell in a pretty tough spot where if he raises rates then some could see it as a politically charged move in spite of Trump, but if he lowers rates then some could say that he bent to the will of the President and the trust in the U.S. central banking system will be lost along with its perceived independence. This puts Powell between a rock and a hard place where any move in interest rate policy could be seen as a political stance. This is the issue that is central to my hedging thesis – the uncertainty of further interest rate hikes.

Hedging with REITs

The biggest reason I’m choosing REITs to hedge with is that while bond yields will rise with the rise in the federal funds rates, REITs generally benefit from the opposite since their industry is heavily reliant on credit for building more properties. This way you can protect yourself on the downside if the federal fund rates are lowered and bond yields go down. To implement this hedge there are three different strategies I recommend for investors to replace a small percentage of what would normally be allocated to bonds to REITs:

1. The buy the basket approach. For the investor looking for broad diversification, looking into a REIT index fund such as the U.S. Real Estate ETF (IYR), with a 0.43% expense ratio, is an excellent place to start. This way you have immediate diversification in the trade (one of Wall Street’s only free lunches) and a relatively low annual cost compared to other ETFs.

2. The pick and choose approach. This approach is for the old school stock pickers looking to pick one or two holdings in an attempt to beat the index. For this strategy I'd focus on five important factors:

  • Comparable yield to bonds (higher than 2%).
  • Large-cap company since they're less likely, on average, to go under than smaller companies adding to the safety factor.
  • Low volatility compared to the S&P since you’re looking replace some of your position that would generally be allocated to low-risk bonds.
  • A low beta to ensure that the company’s stock is less correlated to the movement in the markets.
  • And finally, look for diversification in asset types to try to mitigate some of the cyclical risks from concentrating on specific real estate sectors.

Using these factors I narrowed it down to three companies using some screening tools and some simple excel work. Below are the three companies and how they performed across the five factors I looked at.

Company Ticker Market Capitalization Diversified? Dividend Yield Annualized Volatility
American Tower

AMT

$70 Billion Yes 2.12% 20.33%

Annaly Capital

NLY $13 Billion Yes 11.80% 14.37%
W.P. Carey WPC $11 Billion Yes 6.21% 16.89%

3. Long-Short Sector Neutral. This strategy is mainly geared toward hedge funds with a more sophisticated investing process. Using this method, you can use the factors suggested in the previous strategy (low vol, large-cap, low beta, etc.) to factor all of the REITs in an index (like IYR) and go long on companies that meet all, or at least most of the factors and go short all of the companies that rank poorly on the factors (i.e. smaller companies that have high volatility, high market correlation, and are concentrated on one specific sector). As long as you make sure that you’re 50% long and 50% short within the strategy then you’ll be sector neutral so that if the rates continue to rise and all REITs move down in unison then your longs will lose value and your shorts will gain value leaving you relatively unchanged on the downside (depending on how it looks after net of options fees). Additionally, if the factors discussed above actually do have some bearing on whether the REITs perform well or not and we’re right then the REITs that we went long on will go up while the ones we went short will fall in price meaning that we’ll see double the net gain.

Of course, this strategy, as I mentioned before, is very sophisticated and you should only pursue it at a certain level of AUM and after you have determined how long you can stay solvent on the position based on the fees you’ll have to pay for the short positions.

Conclusion

REITs obviously pose their own risk in times of credit crises but, as long as the sky doesn’t fall then they should give you good downside protection in the event of bonds doing poorly and the Fed deciding to back peddle on rates and – whether because of Trump or not – start to lower rates again.

I think this is a good strategy, but I’d appreciate any feedback below in the comments section if you agree or disagree.

Bonus

Below is the PDF transcript of the interview with Dr. Altman:

Edward_Altman_Transcript_December_13th.pdf

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.