High Yield Options: What’s their Sensitivity to Rising Rates?

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Today there are several different options available for investors searching for high yielding/ dividend securities in a low treasury rate environment. I can only imagine how often a new client walks into a financial advisor’s office and says “if you can get me a nice safe 5% return today I’d be very happy.”

With 30-year treasury rates at 3.57% one has no choice but to move up the risk scale and consider possibilities such as high dividend yielding stocks, preferred stock, high-yield bonds, REITs (real estate investment trusts), MREITs (mortgage real estate investment trusts), MLP’s (master limited partnerships), etc.

Right now my personal portfolio is lacking in yield right now. I have a healthcare REIT (HCP, yielding 5.9%), two high yielding oil rig stocks (Transocean and Ensco, both around 5.5%) and a mortgage REIT (Colony Financial, yielding 6.4%), but no bond or preferred stock exposure (in my actively managed account). I’ve been hesitant to buy bonds or preferred stock over common fears that interest rates will suddenly jump once the economy is back on track and a subsequent drop in principal value will wipe out the benefit of current yield. Hence, I’ve been grabbing yield from other securities that I perceive as less directly correlated to interest rate movements. Today I finally decided to see what the real correlation (extent to which they move in tandem) has been between the 10 year treasury rates and various yield vehicles over the past 7 years:

 

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After running the correlations based on monthly total return data (i.e. including dividends and interest as part of the return) over a few different periods I quickly realized how complex the answer to my initial question proves to be. With the exception of the Total Bond Market ETF (BND), which maintained a strong negative correlation with the 10-year treasury rate over every period tested except the financial crisis of 2009, the other yield vehicles exhibited a wide range of correlations (both positive and negative), making any definitive conclusion difficult. Below are a couple of personal observations based on the data:

• Vanguard REIT Index (VNQ): As I expected there has been relatively volatile correlation between REITs and treasury rates over the past 7 years. If you believe that the economy will continue to steadily improve then I think REITs can make for an attractive yield option in the face of rising rates, particularly given real estate’s ability to act as an inflation hedge. (Keep in mind REITs are more correlated to the market than private real estate funds, however.)

• Preferred Stock ETF (PFF): Correlation between the preferred stock ETF and rates have been extremely volatile over the past 7 years, with the correlation being highly negative in 2013. While the data isn’t conclusive my gut tells me that this vehicle won’t get rocked by rising rates any time soon and has a place in a dividend portfolio.

• High Yield Bond ETF (HYG): When comparing the annual correlations for HYG, which ranged from (0.52) to 0.76, I can’t figure out why the cumulative 7-yr correlation is (0.63). Logically this doesn’t make sense to me but I checked the formulas multiple times and couldn’t find an error. On a cumulative basis it does make sense that the correlation for high yield debt would fall in between that of preferred stock and the bond market overall, however.

• Colony Financial (CLNY): I added this specific mortgage REIT only because it’s one of my favorite investments right now. While classified as a mortgage REIT, Colony has a fairly diversified real estate strategy that includes a large pool of single family homes held as rental product, loan origination, investment in distressed debt world-wide, equity interests in hotels, etc. I bought it as a yield pillar (to borrow a phrase from moMANon) with the idea that their strategic flexibility, low cost of capital and super smart investment team could overcome rising rate risk. So far that appears to be holding up as evidenced by a cumulative correlation against treasury rates of only (.14) since inception of the company.

While this analysis would have been infinitely more enlightening if I could have compared each vehicle over a longer period of time (such as when rates sky-rocketed in the late 1970’s), I hope you manage to find some value in the data as you decide what yield vehicles make sense for your portfolio. As you consider alternative yield options

like the ones mentioned above, it is important to note that they are all very highly correlated with the stock market. In fact, the REIT index, High Yield corporate Bond ETF, Preferred Stock ETF and Colony were all over 0.85 correlated with the S&P 500 over the past 7 years. The total bond ETF was the only vehicle that exhibited low correlation at 0.54.
I’m going to leave you with a chart showing the total percentage returns for the various yield vehicles (as well as the 10-yr treasury rate) since April of 2007:

 

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