Morningstar’s Peter Toogood asks: Is commercial property an alternative to low bond yields?

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Peter Toogood, investment director for Morningstar OBSR, says that with equity markets recording their best January for two decades and bond bulls becoming rare, commercial property may be an attractive option for yield-started institutional investors.

Improving economic data and sentiment and the downplaying of prior “tail risk” concerns was not lost on the financial markets. World equities surged in January, with the MSCI World Equity Index recording the best January in 19 years. January also provided the index’s largest monthly outside of recovery rallies since 2010.

A “great rotation” into equities is still wishful thinking but there is no doubt that bond bulls are an increasingly rare breed. As a risk asset, high-yield bonds have continued to perform well, as investors intensified their search for higher income, but losses were sustained in both government and investment-grade bonds. In particular, the losses on longer-dated maturities are escalating and, as equity markets have soared 15% or so over the past six months, the Bloomberg US Treasury 10-Year Plus Bond Index has lost 8%. The scale and timing of this relative equity gain is perhaps indicative of a trend change as prior moves of similar magnitude in recent years have all been “relief rally”-driven.

One of the biggest issues facing investment managers today is the very low yields on bonds; 10-year government bonds are already at or below 2.0% and investment grade and high yield both hit new all-time lows in January.

For an equally split equity/bond fund, for example, the bond portion of the portfolio is only likely to return around 1.5%, exerting enormous pressure on returns from the equity portion. If the target return is 7 to 8%, for example, equities will need to contribute 6%, which requires a 12% return, a level way above the long-term average and forecast assumptions. This creates a considerable dilemma, especially for lower-/medium-risk funds that in recent years have been able to generate a significant proportion of their returns from bonds.

While UK institutions may not yet be aggressively raising commercial property weightings to access the 7% yield available (compared to 3% on 20-year UK gilts), there are a large number of overseas pension funds and wealth funds that are drastically cutting back on government bond exposure in favour of commercial property.

 

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