Editor's Note

06/21/2007 12:00 am EST

Focus: REITS

Howard Gold

Founder & President, GoldenEgg Investing

Posted June 21, 2007

Remember that famous line from "The Godfather, Part III": "Just when I thought that I was out, they pull me back in"?

Investors might be feeling that way lately. After a respite last week, the Dow Jones Industrial Average fell 146 points on Wednesday, although it rallied Thursday.

The excuse this time? Fear of higher interest rates, of course, though the ten-year Treasury note's yield remained well below its recent highs.

But investors and markets are also jittery about the collapse of two Bear Stearns hedge funds that made bad bets in the subprime-mortgage market. That raised the specter of underlying risk in the financial system, which we wrote about here.

Each time markets have corrected recently-last May, early this March, and again in June-pundits have cited "the repricing of risk." In other words, they expected investors to sell risky assets and return to fundamentals.

That hasn't happened much yet, but it's clear that if rates rise, some investments that have thrived in the era of cheap and easy money will no longer shine.

We're still bullish on US stocks, particularly big blue-chip growth stocks. But if you haven't done so already (as we suggested back in March), you still can protect yourself against growing risk by doing three things.

Sell real estate investment trusts (REITS). Sell high-yield bonds. Sell emerging-market bonds. It's time to get these asset classes, which all have had great runs, out of your portfolio.

REITs, publicly owned commercial real estate companies, have been stellar performers. The FTSE NAREIT All REIT index has rocketed 20.49% annually over the past five years, more than double the compound annual return of the Standard & Poor's 500.

Why? With interest rates falling and growth prospects for commercial real estate strong, institutions and individuals piled in to what was a profoundly undervalued asset near the end of the 1990s, says Professor Christopher J. Mayer, director of the Paul Milstein Center for Real Estate at Columbia Business School.

But it's no longer undervalued by a long shot, as the chart below shows (reprinted with permission of the National Association of Real Estate Investment Trusts).

As you can see, dividend yields on equity REITs have fallen substantially below those of ten-year Treasury notes, which implies that investors think REITs' dividends are safer than Treasuries' yields. That's true, of course, only on Pluto.

What it really means is that investors have bid up REITs' prices-and thus lowered dividend yields-to levels that are "historically unprecedented," says Mayer. And unsustainable, I would add.

Why? Because the prospect of higher rates and a slowing economy make REITs unattractive. The FTSE Nareit Index is already off 18% from its mid-February peak, says Mayer, adding: "I think it can go a lot further." (He's short REITs in a hedge fund with which he's involved.)

Peter Slatin, in Thursday's Gurus' Views and Strategies also sees tough times ahead for REITs. A word to the wise.

High-yield bonds, debt issued by companies that have below-investment-grade credit ratings, also have rallied dramatically. The Lehman Brothers US High-Yield Corporate index is up 12.85% over the last 12 months, and high-yield bond mutual funds have racked up 9.5% compound annual returns during the last five years, says Morningstar.

Again, it's no surprise, given low interest rates, easy credit, and strong global economic growth. No wonder default rates-which determine the health of the high-yield bond market-are near historic lows: only about 1.44% of all high-yield credits couldn't pay their obligations in May, the 40th consecutive month of below-average defaults. Frankly, you'd have to be an idiot to default in this environment.

So, the spread between high-yield bonds and Treasuries has plummeted to nearly two percentage points, its lowest in ten years. That shows investors don't think "junk" bonds are much riskier than those issued with the full faith and credit of the US government.

But these bonds are especially vulnerable to a recession and to contagions in other markets. The rise of "covenant-lite" borrowing in private equity deals-essentially the corporate version of subprime mortgages-could lead to more blowups in the future, like the implosion of the two Bear Stearns hedge funds.

"As the Bear Stearns funds unwind positions, investors and traders could reassess the value of other debt securities," the Wall Street Journal wrote Wednesday. "Investors could find their holdings of similar debt worth less than they thought."

That's also true in emerging-market bonds, debt issued by developing countries, which can range from Turkey and Indonesia to incipient giants like Brazil and India.

These countries have come a long way from the dark days of the early 1990s when the International Monetary Fund and the Federal Reserve had to bail out basket cases like

Mexico. Mineral riches and strong growth have helped push some of them to the forefront of the world economy. Some perennial debtors are even running surpluses.

That's good news for everybody, particularly holders of emerging market bonds, who have profited richly. From the end of 2000 through the first quarter of 2007, the JP Morgan Emerging Markets Bond Index Plus gained 12.8% annually, Bloomberg reports.

Again, that's pushed spreads over long US Treasuries to a mere 1.49 percentage points this month, a record low. It was as high as ten percentage points following the Russian currency crisis of 1998.

Which brings us to the main problem with these bonds. Does anyone honestly think these countries' debt is as safe as ours is? Russia is booming because of oil and natural gas revenues, but it's a complete kleptocracy. China has $1 trillion in US currency reserves, but its banking system is insolvent. What if the stock market collapsed? What if Pakistan dissolved in Chaos? What if the world economy moved into recession? Would you really want to own these bonds then?

Of course not. The markets have given plenty of hints of what's ahead, and riskier assets like these won't be rewarded. Smart investors should take their profits in REITs, junk bonds, and emerging-market debt and run like thieves. Don't say you weren't warned.

Comments? Please email us at TopProsTopPicks@InterShow.com

Howard R. Gold is editor-in-chief of MoneyShow.com. The opinions expressed here are his own and do not necessarily reflect the views of InterShow.

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