Global Real Estate vs. Sovereign Bonds: What’s Better for Low Rates?
Many domestic investors look abroad for higher yielding assets when interest rates and yields begin to fall. While there are many different types of foreign income producing assets, global real estate and sovereign bonds are two of the most popular high yield assets. Investors should carefully consider the differences between these two investment classes before deciding which option is right for their portfolio.
Why Look Global for Yield?
There are many times throughout history where developed countries have suffered from low yields. For example, the United States, Europe, and Japan have maintained unusually low interest rates since the 2008 financial crisis. The United States has begun increasing interest rates in 2016 and 2017, but the European Central Bank (ECB) has zero percent interest rates and the Bank of Japan has negative interest rates, as of late-2017.
Low interest rates tend to lead to higher asset prices since it’s inherently cheaper to borrow money, which means that investors looking for yield in domestic markets might be paying a high price. International markets may offer higher yields at a more reasonable valuation in these cases. Domestic markets may appear attractive due to strong price gains—fueled by low interest rates—but diversification could provide long-term benefits.
Global real estate and bonds are two common asset classes for those seeking yield. After all, real estate investments typically pay out any income from rents (especially in the United States where there’s a tax advantage to doing so) and bonds typically make regular interest payments before repaying a principal amount (with the exception of zero coupon bonds). The question for investors is: What option is best during low domestic interest rate environments?
Investing in Global Real Estate
Global real estate investment may offer attractive risk-adjusted returns compared to domestic options during a low interest rate environment.
For example, the SPDR Dow Jones Global Real Estate ETF (RWO) provided a 3.5 percent yield and 23.58x price-earnings ratio in November 2017 versus a 3.7 percent yield and 36.35x price-earnings ratio for the SPDR Real Estate Sector ETF (XLRE). This means that investors were getting just 0.2 percent more yield in exchange for paying 12x more on a price-earnings basis—although price-to-FFO may be a more accurate measurement.
Global real estate investments also benefit from greater diversification than domestic-only real estate investments. For example, the SPDR Dow Jones Global Real Estate ETF (RWO) has 60 percent exposure to the United States with the remainder divided amongst other global markets. Adverse changes to market conditions in the United States will not have as much of an impact on these funds as U.S.-only real estate funds.
Investing in Sovereign Bonds
Sovereign bonds may offer an attractive alternative to low-yielding domestic bonds during low interest rate environments.
For example, the iShares JPMorgan Emerging Market Bond ETF (EMB) offered a 4.53 percent yield compared to the iShares U.S. Treasury Bond ETF’s (GOVT) 1.68 percent yield in late-2017. Emerging market bonds may be significantly riskier than U.S. government bonds, but the diversified portfolio of an exchange-traded fund helps mitigate those risks. Government bonds also tend to be safer than corporate bonds.
Sovereign bonds may also benefit when developed country interest rate are lower. After all, many corporations in emerging markets issue U.S. dollar denominated debt, which becomes cheaper when interest rates fall and the U.S. dollar depreciates versus a home currency. The downside is that a weaker U.S. dollar can hurt export driven economies that compete with U.S. manufacturers in the global market.
Important Risks to Consider
There are several important risk factors to consider when investing in international real estate or sovereign bonds, including:
- Geopolitical Risk: International investments may have a greater level of geopolitical risk, particularly when the investments are concentrated in an unstable region.
- Currency Risk: Investors must consider the impact of currency conversion of foreign profits back into U.S. dollars when investing in foreign assets for yield.
- Interest Rate Risk: Bonds and real estate are more sensitive to changes in interest rates than other assets, which makes interest rates an important factor to consider.
- Default Risk: Emerging market bonds may be less stable than developed bonds and there have been several instances of defaults over time.