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Bonds, REITs and the instant gratification of yield.

Friday, September 12, 2014

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.


blauereiter said...

Hello Mr Ak71, in your opinion do you the think the future landscape of REITs will continue to deteriorate because of ever increasing FED interest rates ?

Should that happen, what would be an alternative financial product/s ie bonds, etc that can generate a comparable flow of passive income ?

I like REITs because it is relatively low risk and I sleep well at night.

I know you're not supposed to give advice, :P but any calculated insight would be helpful.

AK71 said...

Hi blauereiter,

My view on REITs and bonds in an environment of rising interest rates has been quite consistent. You might want to read the above blog post again. It is all there. ;p

I am not necessarily looking for alternatives and you probably could get an idea of this as I shared my strategy last December: Grow wealth and augment income.

Of course, some things changed and I did a review here:
Portfolio review: Unexpectedly eventful.

Nothing has changed for me since then. :)

Tigerz said...

Are low interest rates the new normal, perhaps? I don't think its just reits that are going to suffer - most shares too. Property investment too. I think the economic eco system of the world is too addicted to it.

AK71 said...

Hi Tigerz,

Oh, I believe all businesses will feel the impact of higher interest rates when the time comes, either directly or indirectly.

However, there will be those which are able to weather the difficult times better than others.

Tigerz said...

Something occurred to me as I tried to understand the various REIT managers' strategies. For example, AIMS Capital Industrial. They have been accumulating properties pretty impressively, but to a REIT investor like me, the DPU stays relatively flat. Evidently because as they accumulate properties, they have to create more shares to raise cash for the purchase which led to DPU dilution. I guess one question is what is compelling value of accumulating properties if DPU remains the similar. I guess they are aiming for around 6-7%. 2ndly, with the impending hike in interest rates, perhaps the REIT managers need to increase the dividend yield per share to continue to make the shares attractive, ie. maintain the gap between dividend yield and deposit rates. Your thoughts?

AK71 said...

Hi Tigerz,

Of course, investors in REITs always like to see more income generated from their investments. However, it just gets quite difficult if gearing is quite high and the management tries to keep a lid on it.

Instead of using debt, management could do some equity fund raising instead. This keeps gearing in check but we might not see any increase in DPU in the near term, post acquisition.

However, there are still benefits from such an exercise such as:

1. Lowering of concentration risk.

2. Having more AUM which could bring down gearing level if no debt was used in the latest acquisition.

There could be other benefits as well which could vary from case to case.

My preference in equity fund raising has always been rights issues but it is more expeditious to have private placements if the fund required is not large.

As for raising dividend yield, this is partly a function of unit price. So, the managers do not have 100% control over this. They could try to increase DPU but if they are already distributing pretty much 100% of the distributable income, there isn't much they could do too apart from trying their best to keep costs down while pushing for higher rentals in due course.

This is why I have cautioned that once the risk free rate goes up, S-REITs' unit prices would come under pressure as the immediate remedy to offering an acceptable return above the risk free rate is a decline in unit prices.

Anonymous said...

Hi AK,

I noticed you like to use Sky Habitat for some of your posts. Are you planning to get a unit there by any chance?

In case you are wondering, yes, I quite like that project too. Too bad its too expensive for me...



AK71 said...

Hi Tree,

Nah, I don't like the Sky Habitat. I think it is really, really high density living in the extreme. Of course, it is too expensive. Maybe, at under $1,000 psf, I might consider. ;p

I have a ready stock of photos and pictures in my C drive which I use to break up my articles although I do put up new photos and pictures sometimes.

OK, making a mental note here that the Sky Habitat picture is overused. ;p

Tigerz said...

Thanks for your opinion and reply.

AK71 said...

Hi Tigerz,

Oh my, I think I must have been talking to myself a bit too loudly again. -.-"

Tigerz said...

Not at all :)

Unknown said...

Hi AK,

I have divested all my commercial REIT (after divested all the 80% of my industrial REIT) like CCT and Suntec when they near the peak, and recently I divested half of my biggest investment MCT also, and diverted part of the fund to the under performing but relatively cash rich counter like the OCBC, Keppelland and Sembcorp(s).

I am not sure if the move is right, but I would think that it might be the last chance that I can divest the REIT at the attractive price. I bought sembcorp marine also recently at 3.95, 3.86, and it seems still remains heading south. I don't understand why the price keeps sinking despite relatively good 2Q result seeing the gross profit improved significantly. With the recent rally of USD, I guess the net profit will improve more significantly (hopefully). You have not been sharing your investment move recently, was it because the share price is too high nowadays that you are reserving pullets for the crash? Thanks.


AK71 said...

Hi Casey,

Thanks for sharing with us your strategy. :)

Personally, I have not been adding to my portfolio. Neither have I reduced exposure in any significant way.

I am shoring up my cash position and my investments in the stock market as a percentage of my portfolio has, therefore, been declining. ;)

Siew Mun said...

Thanks AK,

Autumn, time to harvest :-)
I am formulating my exit strategy to liquidate the REITs that have reached my targeted yield base on capital gains + realized dividend (DPU).

AK71 said...

Hi Siew Mun,

Sounds like you have a plan. Good on you. ;)

Unknown said...


Is there any ways that a retail investor can buy into corporate bonds?

AK71 said...

Hi Wee Teck,

Right now? I don't think so but it is set to change, I believe.

Singapore in retail bond push.
“We are seeing growing retail investor interest in fixed-income products, for example, plain vanilla corporate bonds,” Ravi Menon, managing director of the Monetary Authority of Singapore said at a press conference last week.

“While the risk-return profiles of such fixed-income products are easier to understand, they are not readily available to retail investors.”

AK71 said...

Singapore’s wealthiest residents may be regretting bank rolling the island’s oil industry.

Bonds from oilfield services providers are the worst performers among all local notes this year as the fuel slumped more than 30% since June. Two-year securities of Swiber Holdings, which helps build offshore platforms, are trading about 7 cents below the average price for Singapore debt sold since Dec 31. Most of the debentures were taken by private banks on behalf of their affluent clients.

Singapore’s rich have become the driving force in the island’s bond market, snapping up 86% of the 20 highest-yielding local notes issued this year as the central bank warned about rising sales to individuals.

Swiber and Ezra Holdings are scheduled to repay $720 million of notes within the next two years, or three-quarters of the borrowers’ market value, after funding expansion that helped make oil products Singapore’s biggest export industry.

“Most of the buyers of high yield small deals in Singapore dollars have been high net worth individuals,” Vishal Goenka, the Singapore-based head of local currency credit trading for Asia at Deutsche Bank AG, said in an interview. “As they try to sell, the liquidity or support offered in the secondary market is limited.”


AK71 said...

Reader said...
May I know what are your thoughts on EC world Reit ?

Blogger AK said..
I have looked at this before and I was uncomfortable with its dependence on its sponsor for a big chunk of its income.
In the event that the support disappears, the REIT's distribution yield would decline some 20%.
I also did not like the port which accounted for a third of the REIT's portfolio.

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