Diversifying portfolio with REITs and bonds: Is it worth it?

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Published: Thu 23 Mar 2023, 12:32 PM

Last updated: Thu 23 Mar 2023, 3:40 PM

Every investor today may know or have been advised to diversify their assets to reduce financial risk. But even a well-diversified portfolio is likely to face market exposure, and that is why investors are always told to put their hard-earned money in safe instruments like debt securities or treasury bonds.

By Vijay Valecha

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However, in the past decade, there is growing curiosity among investors towards REITs or Real Estate Investment Trusts. The reason being that the last decade had seen the lowest interest rates in the US, making REITs extremely attractive to investors, which is not the case now. When considering REITs for trading, interest rate environment needs to be observed - being a core element that affects REITs.

But when considering to draft a strategy, one must learn what sets bonds and REITs apart before diversifying their portfolio.

So let’s understand the difference

Treasury bonds are fixed-income investments issued by governments, like the U.S. Federal Department to pay investors a set amount. Investors are given a fixed rate of interest every six months for nearly 20 to 30 years.

As these payments are fixed, a bond’s value is dependent on the prevailing interest rate and the time of maturity. Compared to other investments, treasury bonds are considered virtually safe form of investments since its fully backed by the US government eliminating any chances of default.

REITs, on the other hand, are a form of equity. As a financial instrument, they are invested in companies that earn from either owning or renting commercial real estate properties. Unlike treasury bills, REITs are a form of equity with no maturity dates, and so their assets continue to grow for decades.

As their cash flows grow, REITs stocks tend to provide higher dividends to investors over time and compared to bonds, they have a better capital appreciation.

Having bonds in a portfolio

Since the 1900s, stocks have significantly outperformed treasury bills. This stems from the very nature of bonds being low risk and delivering fixed interest payments.

So, why do strategists still recommend bonds?

Well, for starters, they play a key role in creating a balanced portfolio. Aside from generating a fixed income, they are less volatile. Plus, they have very little correlation with stocks, which means the two asset classes are independent of one another. This translates to a reduction in portfolio volatility. So many financial planners are likely to tell their investors to allocate 60 per cent of capital in stocks and keep aside 40 per cent for bonds as they reach their retirement.

Thus, treasury bonds are considered an excellent option to smooth out returns while delivering a fixed return, especially in times of high market risk.

That should settle it, right?

Even though past performance is a good indicator of achieving long-term financial goals, it is worth noting that the current interest rate scenario is very different from previous times. We haven’t witnessed interest rates as high since 2007 which has resulted in bonds to perform poorly. Such a condition is unlikely to last for a longer period. Historically, the 10-year Treasury yields last yielded 4% in 2007-2008, the safest form of investment offering such attractive yields is rare.

Having REITs in a portfolio

REITs depend on the business’s profitability to acquire more properties, which in turn increases their cash flow and subsequently raises their dividends. This will eventually see the appreciation of their stock prices.

They seem attractive to investors, as by law, they must pay at least 90% of their taxable income as dividends. This has resulted in REITs delivering dividend returns anywhere between five per cent and 10 per cent.

Just like bonds, REITs are affected by interest rate fluctuations in the short term. But as productive assets, they are less consequential in the long term. In fact, since 1972, REITs have outperformed all three major stock market indexes, despite rising interest rates in the 70s and early 80s. Plus, REITs have outperformed stocks and bonds every decade across economic, industry, and interest rate conditions.

So, REITs are the answer, right?

Well, there are some downsides. First, the very nature of REITs, that is, to pay all taxable income as dividends, also ensures it relies on the capital markets for their growth. It means REITs need to issue equity and debt for their businesses to keep growing, and as real estate is not a cheap proposition, it is highly leveraged. This is not a risk, but when the credit market collapses, like the subprime crisis of 2008, weak REITs will be forced to cut their dividends.

Plus, compared to bonds, REITs are more vulnerable to stock market selloffs. But there is something even more critical investors must be aware of. The growth of REITs occurs when debt and equity are issued. So, when it is a REIT bull market, share prices are high, and equity costs are low. But when the market is bearish, they tend to look for fixed-rate bonds to fund their growth. So, for an out-of-favour REIT, their low share prices will raise the cost of equity, making profitability more challenging.

So what is the right mix of bonds and REITs to have?

The best way to go about it is to look at it from the point of asset allocation and risk profile. REITs can be included in one’s equity portfolio, while bonds can be added separately to one’s whole investment portfolio, as they are meant to protect investors from a bearish market. For investors, it is important to remember that they need to use these investments to yield safe returns.

— Vijay Valecha is the chief investment officer at Century Financial.

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