Bonds, REITs and the instant gratification of yield.

The message that inflation is eroding our wealth because the banks here offer such measly interest rates for our savings has become quite pervasive. 

I am sure that the message has been good for sales in some industries too as many more people are worried now. 

I know my parents talk about it a lot more these days.




So, what do people do? They go hunting for higher yields. One of the easier things to do is to go to the banks and invest in products which promise yields which are much higher than the said interest rates. 

Many also go to the stock market to look for stocks, bonds or preference shares which offer yields that beat inflation.

In the hunt for higher yields, we might want to keep this in mind:

"Always remind yourself that investing is a long term activity. So, avoid the instant gratification of yield... think carefully about how you are getting that yield... But there is a tendency in this environment for everybody to feel like 'I've got too much cash rotting in the bank, earning nothing, and I have to do something with it.' ... Don't just buy the highest yielding investment out there. Historically, that's how people get themselves into trouble."  - Tad Rivelle, CIO, fixed income, TCW.

Is the low interest rate environment we see the new normal? Won't interest rates go up again? Pause and ruminate on this for a bit.

When we are offered a high yielding investment, we should ask how the investment is delivering the promised yield and if it is sustainable. If sustainable, for how long is it sustainable? What is the likelihood of a capital loss at various entry prices?

I like how Tad said we should avoid "the instant gratification of yield". 

It sounds similar to how we should try delaying gratification in consumption as we try to build wealth.

By saying that we should avoid "the instant gratification of yield", Tad is probably suggesting that we could possibly get in at a lower price in future and get a higher yield then, everything else remaining equal. 

The suggestion that people who get in now could lose money as prices fall in future is there as well.

I don't know if Tad had a working crystal ball when he said what he said but I know I don't. Could the low interest rate environment persist? 

It could but with experts saying that interest rates could rise sometime next year, shouldn't people in long term and perpetual bonds be worried? 

What about people in interest rate sensitive investments like REITs?

If interest rates should rise, yes, these investors should be worried. However, the bond holders should have more to worry. Why? 

Well, if interest rates rise, it is probably because higher inflation demands it. 

Bonds are not businesses. They are IOUs issued by businesses. They only have to pay the agreed coupon and nothing more. 

Bonds tend to do badly in an inflationary environment as interest rates rise.

For REITs, we can reasonably expect their asking rents to increase in an inflationary environment. There will be constant adjustments made as cost of new debt becomes higher but as long as rents are lifted higher in tandem, there is really no issue, everything else remaining equal. 




So, when investing in a REIT, one of the things to look at is the possibility of higher asking rents in future which involves a whole gamut of considerations which mostly can be neatly sorted under two headings, "supply" and "demand".

When the Fed finally decides to raise interest rates, I am sure that market prices of yield instruments will take a hit just like they did middle of last year. 

How big a hit? 

I have no way of telling but I have an inkling that prices would in all likelihood overcompensate to the downside.

Depending on what our existing investments are, some will suffer more than others but chances of any investor escaping unscathed would be slim. 

So, now, do we liquidate all our investments and do a Chicken Little which is what some people have done?

Well, we could but knowing that I don't really know, my preferred method has always been to stay invested while maintaining a high level of liquidity. 

So, doing what I do means being able to continue receiving income from my investments which increases the level of liquidity that I have.

After all, what is the best way to ride out volatility? Having plenty of cash.




So, bonds or REITs, before we plonk in any money now, we might want to temper our expectations by reminding ourselves of the risk that comes with the instant gratification of yield.

Related posts:
1. Get paid more waiting for opportunities.
2. How to earn 6.3% interest after 4 years?
3. Nobody cares more about our money.
4. Never lose money in REITs or real estate?
5. Perpetual bonds: Good or bad?