The sharp sell-off in North American bond markets Wednesday doesn't look bad in a longer term context and the risks of a Federal Reserve rate hike do not look like a threat to investor returns in dividend-paying equity sectors like REITs. At least not yet.
I'm using the S&P/TSX composite real estate investment trust index as a proxy for dividend investments because it's sensitive to interest rates on two fronts. One, the dividends paid on REITs becomes more or less attractive to investors as the risk-free yield of government bonds changes. Second, real estate companies fund property purchases with borrowed funds, and rising interest rates makes these costs – equivalent to mortgage costs for individuals – higher and the REITs become less profitable.
The effects of bond-market volatility on the REIT sector were clearly apparent in recent days. In large part driven by a hawkish tone from the U.S. Federal Reserve, the Canadian 10-year government bond has climbed from 1.27 per cent to 1.35 per cent since May 13 and the REIT index dropped 1.8 per cent.
The accompanying chart tracks the REIT index against the government of Canada 10-year bond yield. (Please note that the bond yield is plotted inversely to better show the trend – a rising orange line indicates falling yields).
From 2011 to mid-2015, the chart shows the relationship we'd expect with REITs rising when bond yields fall and declining when yields climbed. Beginning in June, 2015, however, the REITs sector remained weak while bond yields fell. A closer look at the real estate sectors shows that the bulk of the damage to index performance for the period was not because of interest rates, but rather, companies such as H&R REIT and Boardwalk REIT, with their substantial operations in Alberta where the weaker oil price adversely affected profits.
The disconnect in the chart underscores the fact that interest rates are not the only factor affecting the values of equity income-related investments; the economy also plays a big role.
As markets have adjusted to new economic conditions and weaker commodity prices, the lines on the chart have begun the process of reconverging. Investors can expect that, unless domestic economic growth surprises, the previous pattern of REIT prices moving in the reverse direction of interest rates should reappear.
Canadian investors can expect volatility in REITs and other equity income sectors until the Fed raises rates and makes their futures intentions clear. That said, I wouldn't expect a major market calamity in the shorter term. The current yield for the REIT index, at 5.8 per cent, should remain well above the Canadian 10-year bond yield and keep the sector attractive for income seekers.
Follow Scott Barlow on Twitter @SBarlow_ROB.