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Canadian real estate investment trusts endured rapid declines averaging 5 per cent between Dec. 10 and Dec. 13 and utility stocks have also been weaker during the month. The obvious culprit behind the weakness in these popular income-generating sectors is rising government bond yields, which make equity-based income streams less attractive by comparison.

The problem is that despite lower stock and unit prices, REITs and utility stocks remain well above where bond yields and their performance history suggest they should be, implying further weakness ahead.

The first accompanying chart compares the performance of the S&P/TSX REIT Index to the Government of Canada two-year bond yield since Sept. 30, 2017 (note that the latter is plotted inversely to better show the trend – a falling blue line indicates rising yields).

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Bond yields vs. REITs, utilities:

Diverging from the historical trend

Gov’t of Canada 2-year

bond yield (inverted)

S&P/TSX REIT Index

1,700

1.0

1,650

1.2

1,600

1.4

1,550

1.6

1,500

1.8

1,450

2.0

1,400

2.2

1,350

2.4

1,300

1,250

2.6

2017

2018

2019

S&P/TSX Utilities

Index

Gov’t of Canada 2-year

bond yield (inverted)

2,550

1.0

2,450

1.2

2,350

1.4

2,250

1.6

2,150

1.8

2,050

2.0

1,950

2.2

1,850

2.4

1,750

2017

2018

2019

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; bloomberg

Bond yields vs. REITs, utilities:

Diverging from the historical trend

Gov’t of Canada two-year

bond yield (inverted)

S&P/TSX REIT Index

1,700

1.0

1,650

1.2

1,600

1.4

1,550

1.6

1,500

1.8

1,450

2.0

1,400

2.2

1,350

2.4

1,300

1,250

2.6

2017

2018

2019

S&P/TSX Utilities Index

Gov’t of Canada two-year

bond yield (inverted)

2,550

1.0

2,450

1.2

2,350

1.4

2,250

1.6

2,150

1.8

2,050

2.0

1,950

2.2

1,850

2.4

1,750

2017

2018

2019

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; bloomberg

Bond yields vs. REITs, utilities: Diverging

from the historical trend

Gov’t of Canada two-year

bond yield (inverted)

S&P/TSX REIT Index

1,700

1.0

1,650

1.2

1,600

1.4

1,550

1.6

1,500

1.8

1,450

2.0

1,400

2.2

1,350

2.4

1,300

1,250

2.6

2017

2018

2019

S&P/TSX Utilities Index

Gov’t of Canada two-year

bond yield (inverted)

2,550

1.0

2,450

1.2

2,350

1.4

2,250

1.6

2,150

1.8

2,050

2.0

1,950

2.2

1,850

2.4

1,750

2017

2018

2019

JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: scott barlow; bloomberg

The relationship between REITs and bond yields was inconsistent from September, 2017, to the end of 2018. From that point to early September of this year, however, falling bond yields were accompanied by a sharp rally in REITs. This pattern is understandable as the lower bond yields made the income stream provided by the real estate sector more attractive in comparison, and REITs were worthy of higher unit prices.

Bond yields bottomed in August at 1.3 per cent and began climbing. Initially, REIT prices seemed oblivious to what was a negative change in trend (for the asset class), but this ended in early October when the sector began falling. To date, the bond yield has risen to 1.7 and the REIT index has dropped 4.6 per cent from the recent peak.

The current divergence between the two lines at the end of the chart implies that unless bond yields begin dropping, REIT prices have further to fall.

The second chart compares bond yields with another favourite sector for dividend investors – utilities. The weakness in the S&P/TSX Utilities Index has been milder than for REITs with a decline of just less than 2 per cent.

The chart shows a stronger, more consistent relationship between utility stock prices and bond yields and this is backed by correlation calculations (not shown). Falling bond yields – a rising blue line on the chart – have been matched by rising utility stock prices and the reverse case has also been true.

At least until the fourth quarter of this year.

A sharp divergence from the historical trend occurred as utility stock prices continued higher while bond yields increased. Just as in the first chart, the current divergence suggests that either interest rates will fall or that utilities prices will decline to close the gap.

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The discussion above is unfairly narrow in the sense that it’s judging REIT and utility asset prices entirely through the lens of bond yields. There are numerous other factors affecting each sector that can become more important that yields for considerable periods.

It remains the case, however, that bond yields have a dramatic effect on asset prices for all dividend-paying equity sectors, not just real estate and utilities. Investors can expect weaker prices as long as bond yields are trending higher.

Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.

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