The bond markets have risen a lot this year, leaving very low yields or negative returns on many bonds. It is true you can still get a better income if you want to take more risk by buying a bond issued by companies that may struggle to repay. There is not so much extra income to be gained any more by buying a bond with a later date of repayment. Traditionally you get higher rewards for lending longer, and higher returns for lending to riskier borrowers, as long as they do not go bust.
In this climate, investors look around for other ways of getting more income. Some buy shares, recognising that their capital values will be more volatile. Share yields are on average much better than government bond yields or deposit income, but bring with them the risk that you could lose much more than the annual income in a market sell off. If the world goes into recession then you would worry more about shares, as that would bring with it lower company turnover and profits in many cases, with the possibility of dividend cuts and more bankruptcies of individual companies. That is why the current argument about whether we will see a world recession or not is so crucial to evaluating the prospects for shares. If interest rates are now low enough to help us avoid recession, then the income on shares is more sustainable and more attractive.
Another opportunity for income comes from property investment. The yields on commercial property in many advanced countries are considerably higher than the yield on government bonds or deposits. It is also often higher than the average income yield on shares. As bond yields tumble more people might find the yield on property attractive. Property income is a bit more reliable than dividend income, as a company usually cuts the dividend before it has to seek some way out of expensive leases it is committed to pay. Commercial property owners usually sign leases for several years with a tenant who may not be able to get out of paying the rent short of going into bankruptcy. If all things are equal as interest rates fall so the yields on properties fall, meaning the buildings go up in value.
Recessions, however, are not good news for property. Whilst property values often respond favourably to lower interest rates, they fall if investors expect a downturn which damages tenant demand and lowers rents. A strong property market requires growing tenant demand so new space is taken up, and buoyant rents that come from decent levels of demand for space. In a recession more companies will go bankrupt, walking away from tenancy agreements, and more companies will expect rent cuts or cheaper rents when taking on new space.
There are challenges
Property as an investment has some other issues. It is expensive to manage, with costs in providing service to tenants, maintaining the building and collecting the rents. It is also difficult to sell when markets become nervous. People and institutions investing in buildings directly need to allow for the possibility that they will not be able to sell their building when they wish for a decent price, and may need to hold on for a long period if the economy enters a recession or bad market conditions for their kind of real estate. There are fashions and trends in property, so industrials and technology space may be in strong demand as the digital revolution sweeps on whilst traditional shops may be suffering from less demand for such space from modern retailers.
This looks like one of those periods when a slowdown in the world economy will produce more central bank and government action to stop it becoming a world recession. This will mean an even bigger gap between the interest rates on your savings account or a government bond, and the yield on a property. Buyers of property who don’t have the money for expensive buildings or do not want to tie it up for a long period can purchase shares in Real estate Investment Trusts. These have some of the characteristics of property and some of shares.
Owners can sell their shares any time the share market trades, though they might have to sell at a discount to the underlying property values in the Trust. The Trust management handles all the property management problems. The yield on the shares will be a lower than the yield of the underlying properties by the amount of the management costs of the Trust. The current yield on the world developed markets property index is around 3.5% which compares very favourably with long-term advanced country bonds.
The above article was previously published by Charles Stanley on 5th September 2019