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opinion

The yield on the Government of Canada five-year bond has roughly doubled since early September, making income-oriented equity investments less attractive. In the case of real estate investment trusts, for instance, the average distribution yield has fallen to levels last seen in 2007 when compared with bonds. The 24-month returns from that point, thanks to the financial crisis, were not pretty.

A secular decline in bond yields over the past three decades proved a huge advantage to income-based investment strategies, motivating asset flows toward distributions and dividend yields. Recent inflation fears, however, have thrown that trend in reverse.

Currently, the S&P/TSX REIT Index pays out 3.6 per cent, only 2.1 percentage points more than the five-year bond yield of 1.5 per cent. This makes the sector far less attractive to income investors relative to recent history – over the past decade REITs have yielded four percentage points more than bonds, on average.

The accompanying chart shows why the smaller yield pickup on REITs (relative to bonds) may be problematic in the coming years.

The chart plots weekly data since 2005, the maximum available for the S&P/TSX REIT Index yield. Each dot represents the difference between the subindex yield and the five-year bond yield (x-axis) and the simple cumulative return for REITs in the 24 months afterward (y-axis).

The upward sloping trend line is what we would expect – the bigger the yield advantage of REITs, the higher the returns over the ensuing period. The dot furthest right, for example, depicts a point in time in the depths of the financial crisis (Nov. 21, 2008, specifically, but dates are not used for this type of scatter chart). At that point, the REIT index yielded a remarkable 11 percentage points more than bonds, and the index jumped 98.5 per cent in the following two years.

The blue vertical line is at 2.1 per cent on the x-axis, showing the current yield pickup for REITs – the difference between the yield on the index minus the bond yield. If we follow the bar upward, the dots that intersect show similar periods in terms of yield pickup as well as the resulting two-year return on the index.

There are, loosely, three clusters of dots that meet the bar. One cluster shows weeks where yield differentials were similar, and forward returns (shown by where the dots meet the y-axis) were in the minus-20-per-cent to minus-30-per-cent range. A different cluster shows performance in the minus-10-per-cent to minus-20-per-cent range. Finally, and more positively, a third series of dots shows eventual returns between zero and 10 per cent. (Distributions are not included in the performance results.)

I would have preferred a longer data series. These results are significant but should only be used as a rough guide. Still, the chart strongly suggests the yield advantage on REITs is low relative to history and investors in the sector may have to temper their return expectations.

As a final note, CIBC World Markets strategist Ian de Verteuil published a report this week predicting a major surge in TSX dividend payouts in the coming quarters. If this includes the real estate sector, and REITs are able to increase distribution yields, then the yield differential could become more attractive relative to bonds.

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