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Reallocate as interest rate rises in a slowing economy.

Wednesday, May 11, 2022

Interest rate is rising.

PM Lee recently warned of a possible recession in the quarters ahead.

Put rising interest rate and a slowing economy together, we get a rather gloomy picture.

The evil which is inflation is preferred to the evil which is deflation.

Although inflation is the lesser evil, it isn't as benign when it is heightened which is what we are seeing now in the world.

We can reduce inflationary pressure either by increasing supply of goods and services which are in demand or tempering demand for such goods and services.

As it is difficult to increase supply right away, central banks are trying to tame inflation by increasing interest rate in an effort to reduce demand.




Increasing interest rate increases the cost of debt.

Credit is the lifeblood of commerce and most businesses are leveraged to some degree.

If the economy is healthy, businesses can pass on the higher cost of doing business to their customers and higher finance expense that comes from higher interest rates are naturally a part of such cost.

However, it becomes more difficult for many businesses to pass on such higher costs to customers if the economy is suffering from malaise.

Heightened inflation, rapidly increasing interest rates and low economic growth is not a good mix.

In such a situation, even very strong companies will not be spared a slowdown as most entities would be less ready to part with their money.





Already, we see some big name MNCs both in the old and new economies warning of very difficult quarters ahead.

Only the fittest will survive but even they might not emerge unscathed from such a toxic cocktail.

As an investor for income, I believe that businesses which are able and willing to pay a meaningful dividend should be favored.

To make sure that dividends are sustainable, these businesses should also provide necessary goods and services and have stronger balance sheets.

They too will take a few punches during hard times but they should be able to roll with the punches.

I think staying invested is still the way to go but, like I said, I should mostly be invested in businesses which are able and willing to pay dividends even during hard times.

So, with this in mind, I have taken a hard look at my largest investments since they impact the performance of my portfolio the most.




The strategy to increase my investments in DBS, OCBC and UOB during the COVID-19 induced bear market has turned out well and sticking with this strategy makes sense to me especially with interest rate rising.

I am also interested in increasing my investments in ComfortDelgro and CLCT on weakness as they seemed to have lagged in price recovery while their businesses look more attractive to me in recent times but for different reasons.

I am leaning more towards ComfortDelgro which has a stronger balance sheet and also because looking at the numbers which have improved, there is a fairly good chance that future dividends will be higher and could even go back to pre-pandemic levels.

CLCT's plan is to increase the proportion of new economy assets in their portfolio and I foresee more fund raising in the future.

So, I will increase my investment in CLCT slowly and not bulk up in a hurry.




REITs are required to pay out at least 90% of their operating cash flow to investors to enjoy tax benefits and this is a source of comfort to me.

The REITs in my portfolio are rather conservative when it comes to debt and in the case of IREIT Global, some of their rental income is linked to the German consumer price index and higher inflation could see a greater increase in income.

In my list of largest investments, the only entity which did not pay a dividend during the last bear market was Centurion Corporation.

Amongst my largest investments, Centurion Corporation also has the weakest balance sheet apart from Wilmar International.

However, Wilmar International is in the business of food production and distribution which, in my opinion, is recession proof. 

Given their size and market dominance, they should be able to charge higher prices.

Wilmar also has good options available to unlock value for shareholders and they were paying dividends even during the pandemic.




I increased my investment in Centurion Corporation as Singapore decided to live with COVID-19.

For those who are interested in my thoughts on the matter, read:

1Q 2022 passive income.

In an environment of rapidly increasing interest rate and slowing economy, however, with a rather weak balance sheet, it could be harder for Centurion Corporation to bring home the bacon.

In my original blog on why I invested in Centurion Corporation, I crunched some numbers on how rising interest rate could impact Centurion Corporation's interest cover ratio.

For those who are interested, read:

Added Centurion Corp to portfolio.

Of course, if they are able to increase asking price per bed meaningfully to balance the increase in the cost of debt, then, they should be OK.

Although they would be able to do so easily in a healthy economy, it might not be so easy during times of economic malaise.




Wait, didn't Centurion Corporation do quite well even when the economy was unhealthy?

Yes, they did but they didn't have to deal with rapidly increasing interest rates.

I don't know everything and I might be missing a few things here.

So, I have decided to only reduce my exposure to Centurion Corporation and not go to zero.

As my total passive income held up quite well during the two years when Centurion Corporation suspended dividend payouts, I doubt reducing my investment would have any meaningful impact in terms of passive income generation which makes this decision an easier one for me.

Although Centurion Corporation still looks undervalued to me as it trades at a huge discount to NAV, to be honest, this discount could reduce as valuation of their assets could take a hit.




It would be interesting to see how the management navigates the challenges ahead and how they might unlock value for shareholders.

They are trying to sell some assets in the USA now which if successful should help in reducing leverage and unlocking value.

To this end, I believe they should ramp up their effort and sell more assets.

Like Phua Chu Kang said at the onset of the COVID-19 pandemic, "Things different already."

In the grand scheme of things, this is a relatively minor shift of resources but because I am more inactive than active as an investor for income, it might seem like a big event.

Remember, mentally unstable AK is just talking to himself, as usual.

Have a plan, your own plan.

Recently published:
Avoid this in a rising interest rate environment.

Related posts:

1. Rising interest rate flashback... 

2. Largest investments 1Q 2022.

3. Investing with peace of mind.




30 comments:

Rellangis said...

Seems like a big bear is coming soon... I think if the feds continue with their promised interest hikes in June and onwards, not sure how the market will react.. could be a buying opportunity.

AK71 said...

Hi Rellangis,

Interest rate is like gravity and higher interest rate will bring things back down to earth.

When the bear comes out of its cave, nothing is spared.

However, some might suffer more serious injuries than others.

Keeping some powder dry is a good idea for when there is blood on the streets.

GP said...
This comment has been removed by the author.
Daniel Yip said...

CDG, Wilmar, SG Banks, REITs

phew, luckily all that you mentioned are in my portfolio

or unlucky?

haha

GP said...


Hi AK,
Since Centurion is facing problem at fast interest rate rising, another REITs like AIMS, will they suffer the same fate? It has significant perpertual, i am not sure if that will affect the cash flow?

GP

AK71 said...

Hi GP,

I didn't trim Centurion only because of its relatively weak balance sheet, it was also because it might suspend dividends if things get worse from here.

AIMS APAC REIT (AA REIT) will probably continue to distribute income which is an important consideration for me as a retiree who depends on dividends for a living.

If AA REIT decides to distribute 90% of income and to retain 10% in future like what IREIT Global has been doing, I think it is not a bad idea.

If we look at IREIT Global, it has a very high ICR and also a very healthy current ratio compared to Centurion Corporation even though IREIT Global is a REIT.

Coming back to AA REIT, there is still plenty of potential for them to do asset enhancement and redevelopment to maximize the plot ratios of many of their assets which should result in higher income.

Given AA REIT's track record in this department, I am hopeful that they will continue to deliver good results.

Centurion Corporation, on the other hand, does not have this option and, in fact, the number of beds might see a reduction as they comply to new standards when it comes to PBWA in Singapore and Malaysia.

Of course, there could come a day when I reduce my investment in AA REIT.

I just don't see any compelling reason to do so yet.

AK71 said...

Hi Daniel,

OMG! Really?

Well, time will tell. ;p

Crossing fingers. -.-"

AK71 said...

Hi GP,

In reply to your second comment, I will wait to see what the interest rate environment is like 3 to 4 years from now as that is when AA REIT will have to decide whether to redeem the perpetuals or to let them reset at the prevailing 5 year SOR + initial spread.

I will also want to see if AA REIT has made progress in generating a higher income by then.

The perpetuals will not affect AA REIT's operating cash flow.

Of course, if the coupons increase if AA REIT decides to go with a reset when the time comes, it could affect DPU if operating cash flow does not increase in tandem.

GP said...

Thanks AK for the explanation!

AK71 said...

Hi GP,

Hey, no problem.

Just talking to myself, of course. ;)

Rae said...

hi AK.

Clct, refer to capitaland retail China trust?

Thank u

AK71 said...

Hi Rae,

Yes, was CRCT but is now CLCT.

They dropped the word "retail" from their name a while back.

Just Capitaland China Trust now. :)

garudadri said...

Dear AK
Nice lucid post
Fully agree regarding SG banks as I have said before- all of them will thrive to an extent unless stagflation sets in, in which case all of us will have a hard time, albeit for a couple of quarters maybe
The three banks have dropped nearly 10%, almost fulfilling the criteria for a technical “correction”
They offer prospective yields north of 4% and buying and holding them will help realize an annualized return of over 10%, if we hold until this cycle of rates peak out - 2/3 years maximum . The figure I quote is of course a conservative one and this is my experience when I bought into the three banks in 2016 correction, 2018 December drop and again in 2020 as well as 2021 lockdown drops
In fact I would argue that the banks offer a better risk return profile as compared to the REITS
I have significant chunks( by my standards only πŸ˜€), in both AA REIT as well I REIT plus some CLCT
I think that these will fall further on account of poor sentiment triggered by the anticipated FED moves thereby offering enticing opportunities in the next few months when I will add to my positions
Entry yields should be at least at 6-7% for any REIT plus they need to have good prospects for investors considering that the ten year SG AAA rates bonds are at 3 nearly, we need a “risk margin” of at least 3-4 %
Wilmar , which I missed out on earlier, is falling and this time I shall lie in wait and start a position for long term
CDG - Rather put more money in above with fuel and wage inflation that will eat into returns , this IMHO will keep dividend yields low and capital appreciation muted.
Regards
Garudadri

AK71 said...

Hi Garudadri,

Thanks for the very detailed comment sharing your plan with us here. :D

For CDG, it isn't just a reopening play to me which would probably mean stronger earnings and better dividends but also because it is really cheap from a valuation perspective when we look at EV/EBITDA.

CDG has been really unloved for so long and it is in situations like this that we get really cheap buys but, of course, cheap could get cheaper. ;p

When it comes to fuel cost, apart from having to pay more for electricity in their MRT business, I don't think rising fuel cost impact CDG's numbers directly.

As for DBS, OCBC and UOB being better investments than REITs especially now that interest rates are rising, I am inclined to agree with you.

Having said this, there are many reasons why I want to add to my investment in CLCT but an important reason is because the Chinese government is going to stimulate their economy unlike the USA.

In such an instance, CLCT's management might also want to look at replacing their offshore loans with onshore ones at some point if it will help to better manage cost of debt.

If Mr. Market's depression worsens, it is time to go shopping. ;)

garyp said...

Phew... all u mentioned also in my portfolio.. i instinctively nibbled abit of gold via OCBC App too lol. Ok Gary Stop! >.<

AK71 said...

Hi garyp,

Is it?

Good to have company. ;p

garyp said...

Yup! Even for CPF SA top up. Guess only diff is that I got STI-ETF instead of indv local banks and buy China banks on HKSE instead. Cos budget conscious la haha.. but I must say your blog stood the test of time. The 不倒翁, unlike other transient and short-lived experts :)

Winnie said...

Hi AK
You talking to yourself in times like this like Beethoven Mozart classical pieces do my ears. :p keeps me at peace.
Do you see the current situation for the stock market as bad as the start of Covid crisis?

AK71 said...

Hi garyp,

We are so lucky to be CPF members.

Maxing out the benefits of our bullet proof CPF membership is such a no brainer. :)

I am not very sociable even in cyberspace.

So, I don't know who are the transient and short-lived experts. ;p

AK71 said...

Hi Winnie,

Aiyoh, AK is definitely no Beethoven nor Mozart lah.

AK is tone deaf, I promise you. (TmT)

It is probably a forgone conclusion that we are in or going into bear market territory.

Bear markets are always same same but different.

It would probably be bad but I don't know if it would be as bad as the last bear market.

We didn't have terribly high inflation and rapidly increasing interest rates in the last bear market.

So much depend on whether the US Fed is able to tame inflation without crashing the economy.

As retail investors, we just have to do what gives us peace of mind. ;)

Hint: See related post #3 in the blog above. ;p

Siew Mun said...

Believe it's still early days. The Fed started their tightening cycle. In June start to trim their balance sheets. By Sep in full swing to trim balance sheet. Money supply noose will get tighter. The Fed is the market maker. Don't underestimate what the Fed will do to tamp down inflation. It is foregone Fed will increase 0.5% Jun and 0.5% Jul and Sep TBD.

AK71 said...

Hi Siew Mun,

Oh, definitely early days.

The Fed has just started and they are very determined to snuff out inflation.

In the process, they could create a recession.

More pain is possibly coming.

Unknown said...

Hi AK,

I would like to seek your opinion on mortgage loan since interest rate is raising.

I am taking "DBS FHR6 + 1.15%" loan. (FHR6 is 0.2% now)
I think FHR6 will not go up above 1% but I may not sure now.
With news of rapid interest rate hike, DBS Fixed 3 years home mortgage is now 2.5% and SSB is average 2.53%, I am not sure how high FHR6 will go up to.

Could you talk to yourself as usual based on your knowledge.
Thank you AK.



AK71 said...

Hi Unknown,

I have talked to myself. ;p

Rising interest rate and home loans.

foolish chameleon said...

Ak, will u be adding more wilmar? =)

AK71 said...

Hi fc,

Couldn't you tell from the way I talked to myself about it? ;p

Looking at the chart, immediate support is at around $4 but if Mr. Market feels extremely bearish suddenly, support could break, of course.

As my average price is much lower, I am in no hurry to add.

If it happens, it happens. ;)

AK71 said...

IREIT Global has secured a lease extension of six years from its sole tenant at Bonn Campus in Germany for 100 per cent of the property starting from May 2023.

In a bourse filing on Tuesday (May 17), the manager said its revised lease with Deutsche Telekom's real estate leasing unit will now expire in April 2029.

Source:
https://www.straitstimes.com/business/companies-markets/ireit-secures-6-year-key-lease-extension-at-bonn-campus-property-in-germany

Eddy said...

Hi AK,
Thanks for the update.
With the ongoing Russian-Ukraine war and the potential economic recession, are u still looking at accumulating more IREIT shares if it goes below 60 cents as previously mentioned?

AK71 said...

Hi Eddy,

IREIT Global is already one of my larger largest investments.

So, unless it goes much lower in unit price, I shouldn't add to my position.

If it was a much smaller investment for me, I would buy some even now.

Still, I might nibble if it dips below 60c.

I am terrible, I know. -.-"

AK71 said...

SINGAPORE, May 23 (Reuters) - Singapore's key consumer price gauge rose in April at its fastest pace in a decade, driven by higher inflation for food, official data showed on Monday.

The core inflation rate — the central bank's favoured price measure - rose to 3.3% in April on a year-on-year basis, the highest since February 2012. A Reuters poll of economists had forecast a 3.4% increase.


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