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Bond yields are rising again, ending a three-month lull and putting yield-sensitive investments such as real estate investment trusts back in the spotlight. How will REITs perform if bond yields explore new highs?

The backdrop is certainly chilling for investors who have stuffed their portfolios with dividend-generating stocks.

The yield on the 10-year U.S. Treasury bond surged from 2.4 per cent at the start of the year to a seven-year high of 3.1 per cent in May, amid strong economic growth, rising inflation and an expectation of additional rate hikes by the U.S. Federal Reserve.

Canadian bond yields followed the action. The yield on the 10-year Government of Canada bond rose from 2 per cent at the start of the year to a high of 2.5 per cent in May, in anticipation of rate hikes by the Bank of Canada.

The dramatic moves weighed on Canadian utilities and telecom stocks, which are often regarded as bond proxies among strategists because of their sensitivity to bond yields: As yields rise, bonds become more attractive to investors. REITs did considerably better, but fell as much as 5 per cent between January and February, perhaps as investors fretted over rising borrowing costs and the possibility of declining property values.

But since May, when bond yields retreated from their highs and then fell off the radar screens of many investors, REITs have roared back to life. They are now up more than 11 per cent this year (including dividends), which is far better than the 1.8 per cent total return for the S&P/TSX Composite Index over the same period. These gains have come even as the yield on the U.S. 10-year Treasury bond returned above 3 per cent on Tuesday, to 3.05 per cent.

In a research note, a group of analysts at CIBC World Markets who follow real estate companies pointed out that this outperformance isn’t unusual. They argued that rate hikes are not the REIT-killers that many investors think they are.

“It’s an all too common refrain we often get from investors when looking at the real estate space: ‘Don’t own real estate in a rising rate environment, it always underperforms.’ Recent performance of the sector would suggest quite the contrary,” Dean Wilkinson, Chris Couprie and Sumayya Hussain said in their note.

The analysts examined the historical performance of the real estate sector and found that REITs tend to do well after interest rates and bond yields have increased.

They looked at seven periods of rising U.S. 10-year bond yields, going back to 2002, and examined how the S&P/TSX Composite Index and REITs performed. While REITs usually lagged the index during these rising bond-yield periods, they were up an average of 3.9 per cent by the time the period ended. That supports the view that investors should stay put.

Even better, the analysts found that six months after the periods ended, REITs tended to outperform the index by an average of two percentage points, with average gains of 19.8 per cent – again, rewarding investors who simply tuned out the rate-related turbulence.

What’s more, during six periods of rising interest rates by the Bank of Canada, going back to 1998, REITs generated a positive performance four times. The sector outperformed the S&P/TSX Composite Index three times, lagged modestly two times and underperformed by a wide margin once (and that was during the tech bubble in 2000). Over all, REITs outperformed the broad index by four percentage points when rates were rising.

“Accordingly, we do not believe that investors should blindly underweight their exposure to real estate if their sole consideration is rising short-term interest rates,” the analysts said in their report.

What’s more important, they added, is the strength of the underlying economy.

Nonetheless, nimble investors might want to consider the advantages of some REITs over others as interest rates rise. The CIBC analysts found that those with shorter-term lease durations, such as apartment REITs, tend to perform better than those with much longer leases, such as retail REITs.

But even investors who have an assortment of REITs, perhaps through an exchange-trade fund, should breathe easy: While rising rates can cause market volatility, REITs might be better off than you think.

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