Interest rates can keep going down. At least that’s what I’m hearing after the RBA cut rates earlier this month to 60-year lows.
But Australia is not alone. Across the globe, money is getting cheaper and cheaper.
This widespread rate cutting and a surge in bond buying by central banks has dragged down the yields of Australian government bonds.
So it’s not surprising that investors are panicking about where their income will come from. There’s little appeal in keeping your cash in the bank, watching it slip away, unable to keep up with the cost of living.
Instead, investors are piling into high yielding investments, pushing share prices higher. They’ll take anything offering a decent income. However, not all high yielding investments are equal.
While their share prices might rise, the operating conditions for many companies are becoming more and more challenging. Valuations are becoming stretched. And that means it will be harder and harder for these companies to maintain their dividends.
Take the high yielding mining stocks for example. With poor operating conditions, many miners are opting to distribute cash to shareholders, rather than invest in their business. This combined with falling share prices make them appear — at least on the surface — like a good way to generate income.
Not so fast. As long as commodity prices remain depressed, many of these companies’ dividends are unsustainable. If you’re thinking about generating regular income from mining stock, think again. Any yield you expect to earn could easily be cut and the pain multiplied by capital losses from falling share prices.
What you want to look for are investments that prosper in low interest rate environments — that is, investments that pay regular dividends and should see their share prices rising in response to low interest rates.
Real Estate Investment Trusts (REITs) are one of those investments. REITs are trusts listed on stock exchanges that hold a portfolio of property assets and trade like regular shares.
Low rates boost the returns on REITs in multiple ways.
Bond yields are critical for property values. Bond yields are the risk free benchmark for all other rates and they set the minimum required capitalisation (cap) rate. Cap rates are the yield that investors demand from a property and are used to compare real estate investments. They are calculated by dividing the rental return by the property’s market value.
What that means is as bond yields fall, property values rise. That’s because rents tend to be fixed so prices must adjust to meet the prevailing cap rate.
Additionally, lower rates mean lower borrowing costs for REITs, leaving more income that can be distributed to shareholders.
And as with other high yielding investments, REITs’ share prices benefit as investors turn to income generating stocks.
REITs have consistently performed when bond yields fall. The good news is that bond rates are going to be low for a long time still.
Following last week’s decision by the RBA, I think we can agree that rates won’t rise in Australia anytime soon. And bets are on the RBA will cut rates again, at least once, this year.
But what about elsewhere?
In Europe, the ECB has set the benchmark interest rate at a record low 0.05% and is buying €60 billion in bonds each month.
The Bank of Japan has set rates at 0% and has also ramped up its quantitative easing program with increased bond purchases.
In China, the central bank cut rates in November for the first time since 2012. The central bank also lowered the capital reserve requirements for commercial banks to encourage lending.
The cash rate in the US is at a record low 0.25% and the Federal Reserve has pledged to keep rates near zero, though we are not sure for how long. The Fed removed ‘for a considerable time’ from its previous statements about keeping rates on hold. The mainstream media took this to mean that the ‘considerable time’ has passed and rates would soon be raised.
However, as Tactical Wealth Editor Kris Sayce points out, if the market really believed the Fed, bond yields would have risen following the recent statement. Yet the opposite was true — bond yields fell sharply. Kris is adamant that, ‘Interest rates are staying low for a long, long time yet.’ And the market appears to agree.
Following an excellent year, Australian REITs (A-REITs) are generally trading above their long term valuations. But given the difference between Australian and US government bond yields, A-REITs are in fact trading at a discount to US REITs.
But I understand that you may be hesitant to invest in listed property. During the GFC, A-REITs were hit much harder than the overall market.
Property trusts suffered because they had taken on very risky levels of debt. But it seems that lessons were learned and A-REITs today have significantly lower levels of gearing than in the past.
You might also be questioning whether there’s anything left in the tank after the exceptional year had by A-REITs in 2014. The ASX 200 A-REIT Index gained 20.44%, well and truly beating the ASX 200’s 1.1% gain.
There are, of course, no guarantees. But as long as conditions continue and yields remain low, I expect listed property to continue to perform well.
However, you should keep in mind that interest rates are low because global economies are weak. Struggling economies aren’t good for property rents. Looking longer term, rents may be unsustainable if global economies fail to recover.
In mid-2014, I recommended a listed property investment to members of the Albert Park Investors Guild. It’s up 30% since then. And just last week I recommended one of Australia’s best A-REITs. It had a standout year in 2014, and for the reasons above, I expect that performance to continue this year.
It’s true that when, or if, global bond yields begin rising, REITs could see a price correction. But for now, I’m convinced excellent returns are still on offer.
Investment Director, Albert Park Investors Guild