Volatile interest rates may push investors towards high-yield bonds and REITs.
That’s because there’s opportunity in the high-yield bond market,” says Barry Morrison, CEO of Aston Hill Institutional Partners.
In fact, he’s already allocated about 12% of that fund to high-yield bonds. The average yield of those bonds is 9.25%, adds Morrison, and their durations are short—about 4.1 years. As such, he’s getting nearly 7% more in income from high-yield bonds versus regular bonds.
“In a rising rate environment, you want short duration,” he explains, “so your bonds mature earlier and you can roll them into higher interest rates [as they become] available. From a bonds perspective, high yield makes sense in rising-rate environments.”
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Yields are at historically low levels. “The yield of [most] bonds that are being measured by the index universe [in Canada] is less than 2.5%,” says Morrison. “Even if rates stabilize and go nowhere, you’re going to make [only] 2.5%. And if you’re buying through mutual funds, your MERs or returns are going to [yield] less than 2%.”
When rates rise, investors may have to sell REITs. REIT returns may not match those of bonds as interest rates rise. REITs had a major correction last year in the market place and they’re now at levels where we’re actually buying some at 8% or 9%, says Morrison. Though absolute returns of 8% or 9% make well-managed REITs attractive investments currently, investors should monitor bond activity going forward.
Markets will overreact to rate changes. This is already apparent in the U.S. stock market. “It’s been up for the last two years and was up 32% last year,” says Morrison. “You’ve got to have a correction at some point [since] the economy isn’t growing at a 30% rate…We’re getting a good correction now in the stock market.” This may affect REITs and bonds, which is why shorter durations are best at this time in the market cycle.
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