Bonds and property - peaked?

Property stocks have given investors who backed them reason to smile, delivering a total return over the past 12 months of 30%, almost double that of the all share index. But after this run, which has pushed property stock indices to record highs, investors may well be asking whether it is time to lock in profit.

The same question can be asked by bond investors, who, over the past 12 months, have enjoyed a total return of 17%, thanks to a sharp fall in interest rates. This is based on the performance of the all bond index . For a foreign buyer using US dollars, the return was 31%.

With the yield on government bonds playing a fundamental role in determining yields on property stocks and hence their prices, the answer for property stock investors is linked to that of bond investors . “Property has strong bond-like characteristics,” notes Simon Pearse, CEO of Marriott Asset Management.

Pearse, whose focus straddles the bond and property markets, points to the dominant role foreign investors are playing in the SA bond market. In their quest for yield, foreign investors have poured money into SA bonds and in the process have driven yields down, says Pearse.

“Foreign investment could continue for some time, no-one can say how long, but it will come to an end,” he says .

Foreign investors have already taken off the table some of the estimated R75bn-R80bn they pumped into SA bonds in the first three quarters of 2010. During the past six weeks or so foreigners have sold upwards of R15bn in SA bonds, says Investec Asset Management’s head of fixed interest, Malcolm Charles.

The impact of their selling on bond yields is apparent: the yield on the government R186 bond has risen from 8% to 8,2% since early October.

More significantly, the strong downtrend in yields has been transformed into a fairly volatile sideways move, typical of a major market move nearing an end.

Backing this possibility, Metropolitan Asset Managers’ Deon van Zyl says: “Bonds [yields] are tracking close to the bottom of the cycle.”

The SA bond market is also strongly influenced by bond yield trends in developed economies, such as the US. This has been particularly evident since mid-2008, with SA bond yields a virtual carbon copy of the trend in US treasury bond yields.

And right now US bond yields are heading higher. For instance, the 10-year bond yield lifted off a 21-month low of 2,4% in early October to its current 2,9%. This is despite the Federal Reserve Board’s recent announcement of a second round of quantitative easing ( QE2), under which it will buy US$600bn of US treasury bonds with maturities of up to 10 years by mid- 2011.

The Fed’s stated intention is to drive interest rates lower, but one of the leading US bond market players, Bill Gross, is not buying that story. Gross has managed the world’s biggest bond fund, Pimco Total Return Fund, for more than 20 years. It boasts assets of $250bn and is hailed by The New York Times as “the nation’s most prominent bond investor”.

“Check [cheque] writing in the trillions is not a bondholder’s friend; it is in fact inflationary,” Gross writes in his November 2010 market review. Sending shivers through bond bulls, he says : “The Fed’s announcement will likely signify the end of a great 30-year [bond] bull market.”

Though this might not hold true for the SA bond market, which has seen yields fall from almost 19% 25 years ago, the global trend now is one of rising long-term bond yields.

Driving the trend is a swing from fear of deflation to fear of inflation after a massive injection of liquidity into the global economy.

For example, since September the UK 10-year government bond yield has jumped from 2,8% to 3,4% and Germany’s from 2,1% to 2,7%. In Australia, where the central bank has adopted a counter-inflationary stance, the 10-year yield is up sharply, from 4,3% in August to 5,5%.

SA’s low inflation rate (3,2%) is the consequence of the rand’s strength, Pearse says. He believes that over the next 10 years inflation will be in the 7%- 8% range.

Van Zyl sees inflation back at 5%-6% within 18 months.

Neither view is bullish for bond yields, nor property stocks, which are also experiencing deteriorating fundamentals at a time when their average yield (6,9%) is 120 basis points below bond yields. Only 18 months ago property stock yields were on par with bond yields.

Property’s big advantage over bonds, rising income distributions, is also fading as SA’s economic slowdown steadily takes its toll when leases come up for renewal. This is already evident in distributions by property loan stocks, which, according to the Property Loan Stock Association, fell from peak year-on-year growth of 19,6% in the first quarter of 2008 to 5,95% in the third quarter of 2010, the lowest increase in 18 quarters.

Property cycles run for up to 10 years and are divided into periods of poor and high returns, says Pearce, who believes that property has entered a period of poor returns .

Marriott Property Equity Fund holds the minimum permitted 50% of its assets in property stocks and has used derivatives to reduce its effective exposure to 35%.

Other property experts may share Pearse’s view that property valuations are stretched, illustrated by a spate of initial public offers (IPOs) and capital-raising exercises , developments that have often portended a market or sector peak.

Not least of these is Old Mutual ’s planned IPO of its Triangle Real Estate Fund. The total value of the listing will be about R12bn, including a targeted R5bn to be raised in the IPO scheduled for mid-2011. This would make the fund the JSE’s third-largest listed property entity.

“At least half of the listed property companies have raised or are preparing to raise capital,” says Evan Jankelowitz, Stanlib’s former head of property investment. He is launching a new property asset management firm. There are other potential IPOs in the wings, he says .

Though property will always have a place in a diversified portfolio, current developments in the sector’s underlying fundamentals point strongly towards the need for caution.

Pearse warns: “Don’t fall into the trap of believing this time it’s different. Ultimately it’s never different.”

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