This article was originally featured on Morningstar.

com, The Online Investor, National Real Estate Investor and two others April 23, 2012.

Escaping Higher Bond Rates

Submitted by David Gratke on Mon, 04/23/2012 - 12:00pm Bondholders are dreading the inevitable rise in interest rates. When rates rise, bonds generally lose value. But there are alternatives for fixed-income investors that wont suffer, or at least not as much: real estate investment trusts (REITs) and convertible bonds. With interest rates at historic multi-decade lows, investors can no longer turn to bonds to reduce risk. After a three-decade decline, rates will rise sooner or later. Now, $9 trillion dollars is in the global economy from central bank printing that was not there five years ago. Historically, bond managers used shorter maturity bonds to manage interest rate risk. This allows them to capture the principal back sooner, for re-investment at higher rates during rising interest rate environments. Plus, when rates rise, shorter-term bonds do not depreciate in value as much as long-term bonds. This strategy is not as viable as it once was, however, because rates for almost all bonds are so low: The benchmark 10-year Treasury yields around 2%. Convertibles and REITS, both publicly and non-publicly traded, have low or negative correlations to stocks and other bonds. Correlations tracks the way two assets relate to each other. A correlation of 1.0 means the two assets rise and fall exactly alike. The lower the correlation, the less they move together. A negative correlation means they move opposite one another. Convertible bonds. These bonds can be switched into a fixed number of a companys common shares. The conversion takes place when the common has risen to a certain price. While you are waiting, you collect bond interest, although usually not as much as the companys regular bonds pay.

Converts are less impacted in price than traditional bonds amid rising interest rates. Reason: If the bond market is falling apart, people may rush into stocks, giving convert owners a potentially lucrative escape option. Compare the SSI Convertible Income Strategy, a portfolio of converts assembled by SSI Investment Management, with key equity and bond measures. When the stock market falls, converts dont tend to drop as much as their underlying shares. Thats reflected by the SSI portfolios low (0.44) correlation with the Standard & Poors 500 stock index. The convert portfolios correlation to the Barclays Long-Term Bond Index is negative 0.06. Plus, its objective is a dividend return of 6% to 7%. (Minimum investment: $1,000.) REITs. Real estate has typically displayed low correlations to traditional market indexes, as well. Most REITs are landlords: They own commercial buildings and generate earnings from rents, providing nice dividend income for investors. According to the National Association of Real Estate Investment Trusts, the yield averages 3.4%, higher than a 10-year Treasury and the S&P 500 (both around 2%). Commercial buildings are vulnerable to economic downturns. They run the risk of high vacancy rates, which happened during the Great Recession. But REITs high payouts help cushion them. Since the recessions end, vacancies have fallen. In 2008, the FTSE-NAREIT AllREIT Index fell as far as the S&P 500, but has outstripped it in the years since. This REIT index has a fairly high correlation (0.74) to the Russell 3000 stock index, a broad-market benchmark like the S&P 500. But whats important to bond investors is that REITs equity-like characteristic gives it a negative correlation of 0.11 to the widely referenced bond index, Barclays Aggregate Bond Index. Non-listed REITs are even less correlated to stocks (0.17) and bonds (negative 0.08) over the past 15 years, according to Versus Capital Group. These REITs, as the name suggests, do not trade on exchanges like other property trusts.

Investing in them is a lot like buying a bond: The shares are redeemed at a fixed price, often after 10 years. Meanwhile, you enjoy high dividends. The downsides are that non-traded REITs are difficult to get out of before their term elapses.
One way around this illiquidity is a new closed-end mutual fund that invests in real estate private equity funds, called Versus Capital MultiManager Real Estate Equity Income Fund (VCMRX). It trades like a stock. The fund has stakes in blue chip organizations like UBS Global Real Estate and J.P. Morgan Global Real Assets. With a minimum investment of $10,000, the fund aims for a 5% to 5.5% dividend yield.

David Gratke is chief executive officer of Gratke Wealth LLC in Beaverton, Ore.

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