Out of favour Reits offer contrarian rate bet

This is a tough time for contrarians looking for bargains in the US equity market. Everyone is still enjoying the dance. Bad news does little or nothing to dent enthusiasm.

There is, however, at least one sector that has conspicuously failed to join in the party. Real estate investment trusts started to drop sharply back in May, and have not recovered. Virtually the entire sector suddenly went out of favour.

Using the FTSE-Nareit indices, US Reits are down 10.1 per cent since the beginning of May, even when yield is included, while the iShares Mortgage Real Estate exchange-traded fund, which tracks the Nareit index of mortgage Reits, has fallen 19.8 per cent. Meanwhile, the S&P 500 has gained 15.4 per cent.

There is an obvious reason for this. Reits are an interest rate play. Reits rely on debt markets to finance their attempts at growth, making them rate-sensitive.

They are required to pay out at least 90 per cent of their taxable income in dividends each year to maintain their status. With short-term interest rates held close to zero by the Federal Reserve, this made Reits very attractive – especially as they can now easily be bought through exchange traded funds.

Once the Fed started talking about “tapering” its monthly bond purchases, it was no surprise that bond yields rose and Reit shares fell.

The response to the Fed’s decision not to taper in September, however, has been surprising. Stocks have set new highs, but 10-year bond yields are still a full percentage point above where they were when taper talk started in May. Other instruments popular for their high income, such as utility stocks, high-yield bonds and master limited partnerships holding oil pipelines, have recovered significantly. Yet Reits are bumping along, barely above their lows for the year.

Reit opportunity?

Could this have created a Reit buying opportunity? There are two ways this might happen. First, the market may be wrong about interest rates. The consensus expectation is that tapering will happen fairly early next year, probably in March. While not great for Reits, the sell-off so far should have taken much of this risk into account.

If this does not happen, or if incoming Fed chair Janet Yellen succeeds in jawboning bond yields downward with strong forward guidance, then securities that offer an income will be popular again. That points particularly to Reits which hold mortgage-backed bonds – which have recently fallen far out of favour. A recent brutal sell-off hit Reits such as Annaly (now at its lowest level in more than a decade) and American Capital (at a four-year low), which hold bonds issued by the federal mortgage agencies and fund themselves largely through the repo market. When rates are rising, leveraged plays on mortgage-backed bonds are naturally unpopular, so these could be value traps.

What are the chances the market is wrong about rates? Under Mr Bernanke, the Fed tried to persuade traders that tapering was not the same as tightening monetary policy, and failed. Ms Yellen is geared to make another attempt; staff at the central bank have had an extra year to make their case, and this time they may succeed.

Also, the US economy might fail to continue its recovery, causing rates to fall.

Look for value

A second way for Reits to offer value lies in the way investors bought them during the upturn. The average Reit buyer would have been unlikely to have taken notice of any statistic other than yield, and buying through ETFs – almost by definition indiscriminate – has dominated the sector.

So, anyone with a grasp of how to value a Reit should be able to find bargains. Look for value, and for Reits whose line of business gives them a chance of strengthening in line with the market – even if rates rise and the economy recovers.

As a whole, US equity Reits trade at a discount of 6.8 per cent to net asset value, according to SNL Financial. But some are at a far deeper discount, with multifamily rental Reits selling for 18 per cent less than their net asset value.

Is this as tasty as it looks? Jason Lail, manager of property research for SNL Financial, suggests this sector could offer protection if rates rise as expected. Demand to rent apartments might rise if mortgage rates rise, putting ownership out of reach for many. And if the economy is strengthening, the army of twentysomethings now living with their parents might have enough money to rent.

Another sector that should benefit from an economic rebound is hotels (whose “leases” are renewed every night, and which trade at slightly below their net asset value).

Any move into Reits is a bet that the market is wrong about rates. But for anyone who thinks US rates will fall or stagnate next year, Reits repay close study. After an almost uniform rise in the US market, they appear to be the most attractively priced way to make that bet.

Source: http://www.ft.com/intl/cms/s/0/9520ba6a-56b7-11e3-8cca-00144feabdc0.html#axzz3PTZUNDox

QE and ultra-low interest rates: Distributional effects and risks

There is widespread consensus that the conventional and unconventional monetary policies that world’s major central banks implemented in response to the global financial crisis prevented a deeper recession and higher unemployment than there otherwise would have been. These measures, along with a lack of demand for credit as a result of the recession, contributed to a decline in real and nominal interest rates to ultra-low levels that have been sustained over the past five years.

 

MGI’s Richard Dobbs and Susan Lund discuss the economic impact of QE and ultra-low interest rates and the problems that may arise, depending on future conditions.

A new report from the McKinsey Global Institute examines the distributional effects of these ultra-low rates. It finds that there have been significant effects on different sectors in the economy in terms of income interest and expense. From 2007 to 2012, governments in the eurozone, the United Kingdom, and the United States collectively benefited by $1.6 trillion both through reduced debt-service costs and increased profits remitted from central banks (exhibit). Nonfinancial corporations—large borrowers such as governments—benefited by $710 billion as the interest rates on debt fell. Although ultra-low interest rates boosted corporate profits in the United Kingdom and the United States by 5 percent in 2012, this has not translated into higher investment, possibly as a result of uncertainty about the strength of the economic recovery, as well as tighter lending standards. Meanwhile, households in these countries together lost $630 billion in net interest income, although the impact varies across groups. Younger households that are net borrowers have benefited, while older households with significant interest-bearing assets have lost income.

 

Ultra-low interest rates have had distributional effects on interest income and expenses.

 

The impact that ultra-low interest rates have had on banks has been mixed. They have eroded the profitability of eurozone banks, resulting in a cumulative loss of net interest income of $230 billion between 2007 and 2012. But banks in the United States experienced an increase in effective net interest margins and a cumulative increase in net interest income of $150 billion. The experience of UK banks falls between these two extremes.

Life-insurance companies, particularly in several European countries, are being squeezed by ultra-low interest rates, so much so that if this environment were to continue many of these insurers would find their survival threatened.

Theoretically, ultra-low interest rates may have resulted in higher asset prices, and this effect may have offset lost interest income for households and other investors. But we find a mixed picture.
Rising bond prices are the flip side of declining yields, and the value of sovereign and corporate bonds in the eurozone, the United Kingdom, and the United States increased by $16 trillion between 2007 and 2012. Investors that mark the value of their assets to market have therefore seen a significant gain on their fixed income investments, at least on paper.

Ultra-low interest rates are likely to have bolstered housing prices by lowering the cost of mortgage credit. This effect is most clearly seen in the United Kingdom, where the majority of mortgages have variable interest rates that have automatically adjusted downward. The impact is less clear in the United States, where the recovery in housing prices has been dampened by an oversupply of housing, high levels of foreclosures, a predominance of fixed-rate mortgages, tightened credit standards, and the prevalence of homes with negative equity whose mortgages cannot be refinanced.

We found little evidence that ultra-low interest rates have boosted equity markets. We cannot discern a large-scale shift into equities as part of a search for yield by investors, and price-earnings ratios and price-book ratios in stock markets are no higher than long-term averages. Although stock prices do react to announcements by central banks, these are transitory effects that do not persist.

If one accepts that housing prices and bond prices are higher today than they otherwise would have been as a result of ultra-low interest rates, then the increase in household wealth and the possible additional consumption it has enabled would far outweigh the income lost to households. But we are skeptical about whether increases in wealth have translated into higher consumption in today’s environment, given that housing prices in the United States remain far below their peak. Moreover, it is more difficult for today’s households to borrow against any increase in wealth because of tighter credit standards.

Ultra-low interest rates do appear to have prompted additional capital flows to emerging markets, particularly into their bond markets. Purchases of emerging-market bonds by foreign investors totaled just $92 billion in 2007 but had jumped to $264 billion in 2012. Emerging markets that have a high share of foreign ownership of their bonds and large current account deficits will be most vulnerable to capital outflows if and when central banks begin tapering current policies.

There are likely to be risks ahead whether asset purchases are tapered and interest rates rise or, alternatively, if current monetary policies continue and interest rates remain low. In the first scenario, the benefits gained or losses incurred could be reversed. Government interest payments on debt, for instance, could rise up to 20 percent. Amid anecdotal evidence that some investors have increased their leverage to amplify returns in some markets, rising interest rates could lead to a collapse in leveraged trades and could pose a threat to some financial institutions. Capital flows to emerging markets could reverse. Investors in bond markets forced by accounting rules to mark to market could face large write-downs. Eurozone countries could be caught in a crosswind if rates increase in the United States before they do in Europe, leading to a shift in foreign capital from Europe to the United States. In the second scenario, life insurers and banks in Europe would experience continued erosion in their profitability. A continuation in ultra-low interest rates could also prompt higher leverage and the return of asset-price bubbles in some sectors, especially real estate.

Source: http://www.mckinsey.com/insights/economic_studies/qe_and_ultra_low_interest_rates_distributional_effects_and_risks

End of QE will test diversification faith

Diversification, the great free lunch of investing, is often taken for granted by investors. Bonds and equities have acted as effective portfolio diversifiers for much of the new millennium because of their different return and volatility patterns. Two of the three main assets in a typical portfolio, cash being the third, moved in opposite directions during financial crises such as 2001 and 2008.

Indeed, portfolio management has become accustomed to this trend and now treats it as an article of faith. But does this faith represent a dangerous cocktail of overconfidence and extrapolation?

The mantra that monetary policy is driving market returns is well rehearsed. Less obvious is the idea that policy is driving the relationship between bond and equity returns.

This year gave a flavour of things to come: a period of high turbulence in May and June as markets took on board the possibility the global liquidity flood was about to abate. Bonds fell sharply and equities stumbled as investors fretted about an end to the Federal Reserve’s emergency asset-buying. Price volatility rose in both mainstream asset classes. Using US equities and 10-year bonds as proxies, the correlation was negative from 2009 to the middle of this year and positive thereafter.

Shock absorbers

Next year could mark a turning point as policy makers exiting the triage phase of recovery from the Great Financial Crisis move away from a material reliance on monetary activism into the potentially more volatile territory of forward guidance.

What does this mean for fixed income? Suppose there is one dominant, price-insensitive buyer (the Fed). Now suppose this buyer has a progressively smaller wallet. All other things being equal, the volatility of prices rises as buyer and seller strive to match each other. Add in another group of (reasonably) price-insensitive buyers (China and the like) downsizing their spending due to slowing growth in foreign exchange reserves, and this risk expands.

Of course, there are shock absorbers. First, the developed world’s ageing populations and their agents (think insurers) have a structural bid for yield. Second, the Bank of Japan is expanding its monetary easing . Some of governor Haruhiko Kuroda’s largesse eventually will pass through Narita Airport as growing shortages of domestic bonds force local institutions to shake off some of their home bias. The conclusion? Do not expect a fixed income bloodbath in 2014 – but brace for more volatile returns.

How about equities? 2013 will probably be known as the Year of Equity. The problem: the numerator of the price to earnings ratio (price) has been driving returns in most markets this year, rather than the denominator (earnings). Higher pricing of the final claim on corporate cash flows – equity – has been aided by the tightest debt spreads on record, insatiable demand from yield-hungry investors, and the ability to refinance and extend fixed obligations at low cost. This works well for a while, but at some point earnings need to come through.

Theory has it the discount rate partially connects bonds (fixed coupons discounted by an interest rate) and equities (fluctuating cash flows discounted by this interest rate plus some variable risk premia). Here is the rub: arithmetically, the lower the real interest rate, the greater the volatility triggered by small changes. If the major driver of returns (policy) becomes more volatile, so do the assets that have benefited from that support.

QE tide turns

Clearly the unprecedented monetary stimulus tide will not last forever. When it dwindles, what will become an effective diversifier of portfolio risk? Bonds or equities? Not entirely; see the drawbacks described above. Cash? Perhaps, but if rates rise for longer-dated bonds and remain anchored by policy for short-dated issues, the diversification benefit of a near zero return is limited.

Challenging the assumptions of the past at a time of regime change is vital in financial markets. This means rethinking fixed income to seek out relative value between bonds, capitalising on rises in volatility and harvesting risk premia. In other words, taking an unconstrained approach. It means a focus on alternative strategies that do not start with the discount rate. Examples are infrastructure and real estate debt, opportunistic acquisition of long duration assets chased off bank balance sheets by regulation and market neutral long-short strategies.

Any reversal in the policy tide involves uncharted territory. A reversal in the 30-year downward trend of rates must, however, involve some different results. 2014 may very well become known as the year in which unwary investors ask: “Who stole my diversifier?”

Source: http://www.ft.com/intl/cms/s/0/0687562c-5e7f-11e3-8621-00144feabdc0.html#axzz2nwa2gnpW

France in Fed taper line of fire

When France’s weak economy and public finances are panned by international critics, its politicians have an easy riposte: just look at our bond yields.

Paris can borrow at lower costs than London, and the spread between French over German 10-year bonds has remained remarkably stable over the past year. Standard & Poor’s early morning announcement two weeks ago of another downgrade – this time to double A – failed to cause markets to choke on their croissants. Investing in French assets cannot be so awful.

Could that change as the US Federal Reserve starts to wind back its exceptional stimulus measures? Among investors I have spoken to recently, a school of thought is developing that it might.

During the global “taper turmoil” earlier this year – the weeks after May 22, when Ben Bernanke, Fed chairman, first hinted at his plans to taper, or scale back Fed asset purchases – eurozone bond markets remained surprisingly tranquil, even as emerging markets sold off sharply.

But while global policy makers and economists still struggle to understand the interlinkages between Fed actions and global markets, it seems implausible that Europe can escape unscathed when tapering becomes real, perhaps as early as December. After all, “global QE” – quantitative easing by the Bank of Japan as well as the Fed – drove European bond prices higher and yields lower; taper turmoil showed the potential for disruption when it goes into reverse.

Stabilising factors

If there will be European fallout, where will the effects be worst? Intuitively, the weaker eurozone “periphery” economies seem most at risk of a market correction as global QE ebbs, especially if fresh taper turmoil increases investors’ risk aversion.

In fact, countries such as Spain, Italy and Ireland have benefited from four stabilising factors this year.

First has been their transition – thanks to the European Central Bank acting as a backstop – from existential crises to something nearer normal economic conditions. Growth is low and unemployment alarmingly high, but the danger of imminent ejection from the euro has gone.
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Second, at least Irish and Spanish bonds have benefited as turnround stories, with tangible evidence of structural reforms improving competitiveness and growth prospects.

Third has been the “re-domestication” of Spanish and Italian bond markets – fickle foreign investors have fled.

Fourth, eurozone periphery countries have moved decisively from current account deficits to surpluses; they no longer rely on capital from overseas.

All four supporting factors will remain in place even as the Fed tapers. None, however, apply to France. Instead other reasons explain the impressive performance of France’s bond market this year – and why it might now be vulnerable.

Higher bond yields

When the Fed was ramping up its asset purchases and US Treasury yields were falling, global investors looking for higher returns were attracted by France’s large and liquid bond markets. Until June this year, French 10-year yields were higher than US equivalents.

France was considered part of the eurozone’s safe, northern core, which made it attractive to investors for whom German Bund yields were simply too low. The Swiss central bank was an avid buyer of French bonds, as were Japanese banks.

"Whatever the risks posed by Fed tapering, it is hard right now to see what might trigger another big sell off"

The case against France is that if the Fed slows its asset purchases and US Treasury yields rise, those inflows could start to reverse and French bonds would sell off – perhaps sharply.

Eric Chaney, chief economist at Axa, points out the very different debt profile between France and Germany. As a share of GDP, French public sector debt will soon be 20 percentage points higher than Germany’s. Without action to alter France’s debt dynamics, the spread between French and German bonds could widen by 50 or 100 basis points, warns Mr Chaney.

French politicians probably need not worry just yet. Investors shorting French bonds have often lost their berets.

When French yields have hit instability in the past, it has been because of obvious systemic risks – the exposure of its banks to the eurozone “periphery” economies in 2011, for example. Whatever the risks posed by Fed tapering, it is hard right now to see what might trigger another big sell off. As the eurozone crisis has lost intensity, eurozone bonds have performed more like “rates” markets, with yields linked to growth and inflation prospects, rather than default risks. France’s economy is contracting, which will curb any uptick in yields.

Still, as Fed tapering draws near, markets may make life less comfortable for French politicians – and limit their bond yield bragging possibilities.

Source: http://www.ft.com/intl/cms/s/0/d1742d9e-5149-11e3-b499-00144feabdc0.html#axzz2lIoVJMpj