While the Federal Reserve’s latest monetary policy report offers an optimistic take on the unprecedented measures that are being taken to stabilize the U.S. economy, the long-term consequences of their actions remain uncertain. As the central bank’s response to COVID-19 enters increasingly uncharted waters with the purchasing of corporate bonds, new concerns regarding the impact on public markets are beginning to surface, underscoring the continued need for investor caution and ample portfolio diversification.
Below we cover three interconnected concerns regarding the stock and bond markets that we believe investors should take into account, before ending with three potential benefits commercial real estate investments are in a unique position to offer, namely income visibility, inflation hedge, return potential.
1. The Fed’s lenient criteria for its corporate bond purchases may artificially extend the lifespan of fiscally unsound businesses
The Fed’s move to buy up to $750 billion in existing corporate bonds on the open market, as opposed to newly issued debt, is intended to lighten the cost of corporate borrowing in order to help businesses weather the COVID-19 pandemic.
However, since the Fed is willing to purchase bonds from issuers which were rated BBB-/Baa3 (depending on the agency) as of March 22, the Fed may in effect be acting as an underwriter for riskier corporate debt, given that the Fed is eligible to purchase bonds from issuers which have since been substantially downgraded. The US corporate sector was already highly leveraged prior to the COVID-19 outbreak, and with this massive bond-buying program the Fed runs the risk of enabling wildly mispriced “zombie companies” kept alive by low interest rates and readily available credit.
Furthermore, the Fed’s bond-buying program disproportionately benefits large corporations with ready access to credit markets, and unlike the Paycheck Protection Program has no requirements for companies to retain workers. This leads to a heightened risk of large corporations exploiting the bond-buying program for cheap capital while skirting the congressional lending guardrails put in place to ensure responsible business operations.
As a result, this generous bond-buying program runs the risk of distorting public market price discovery, thereby creating an additional layer of uncertainty for investors looking to public market investments as a source of long-term value creation.
2. In spite of the bond-buying program’s potential risks, many investors view the Fed’s recent action in wholly bullish terms
Since the bond-buying program lowers the returns from investing in bonds, it has encouraged an increasing number of investors to shift money away from corporate bonds into stocks and other investment opportunities in hopes of achieving higher returns.
This partially explains why so many retail investors have recently begun gambling on bankrupt companies such as Hertz or highly-leveraged and distressed retailers like J.C. Penney. As Senator Toomey put it during the latest Federal Reserve semi-annual congressional testimony, the Fed’s bond-buying program “clearly picks borrowers over lenders, creating problems for insurance and pension funds and distorting price signaling.”
In tandem with the Fed’s commitment to maintaining near-zero interest rates through 2022, the current surge in corporate borrowing has the potential to create bull traps within equity markets which can compromise retail investors and complicate the transition back to a healthy post-pandemic economy.
3. With market sentiments increasingly fluctuating between the extremes, there is a growing disconnect between public market performance and reality
Given the unprecedented nature of the current pandemic, stock market pundits have never been so polarized in their economic outlooks. Multiple investor sentiment indexes indicate that investor sentiments continue to fluctuate wildly between extreme optimism and pessimism, with positive surprises reflecting extremely low expectations and unexpected bad news often resulting in catastrophic downturns in investor sentiment.
And while extreme sentiments don’t necessarily directly translate to near-term market surges or pullbacks, these mood swings indicate that stocks are currently more vulnerable to triggers which may not closely track with market realities, particularly during an election year.
The combination of capricious market sentiments and suspended disbelief regarding recent market movements has resulted in an unsteady environment for investors nervously eyeing their equity allocations, who must simultaneously gauge unprecedented swings in business conditions as well as emotions-driven expectations.
Given the current public market turmoil, over the long-term real estate’s defensive features can potentially provide investors with a degree of risk mitigation
Real estate’s value proposition, particularly for demand-inelastic assets such as rental housing units, is driven by deep-rooted societal needs. And as a testament to real estate’s long-term value-generating potential, an estimated 87% of all public sector pension funds and 73% of all private sector pension funds now invest some portion of their portfolios in real estate. Below are three ways investors can potentially benefit from their real estate investments under current market conditions:
1. Income visibility: for real estate assets geared towards long-term leases, rental cashflows are highly predictable given the right tenant composition. In fact, the latest figures show a decline in apartment turnover rates relative to last year, which has helped owners maintain occupancy and cash flows throughout the crisis to date.
2. Inflation hedge: with long-term concerns of inflation increasing among investors as a result of the extreme quantitative easing the U.S. is experiencing, real estate may offer a significant hedge given that rents are typically dynamically benchmarked in accordance with geography and sub-asset class.
3. Return potential: the current yield premium between real estate and many government bonds is significantly higher than historical baselines, and the persistently low interest rates endorsed by the Fed have created a significant premium over most fixed income securities for the foreseeable future.
The Fed’s bond-buying program will undoubtedly have some stabilizing effects on the national economy, but under such a broad program it’s important to recognize that there will be competing macroeconomic effects, not all of which necessarily bode well for retail investors. Therefore, while no investment option is risk-free we believe that hard assets such as commercial real estate can provide a much-needed source of diversification for investors looking to cover their bases and establish a buffer between their assets and the whims of the public market.
Therefore, as you look for ways to maximize long-term value creation it may be worthwhile to take a closer look at why an increasing number of institutional and retail investors alike are allocating into real estate.
As always, iintoo’s team of Licensed Investment Specialists is available to discuss your investment goals and provide more details on our private placement commercial real estate offerings. Learn more here.