Jeffrey Gundlach is the founder of Doubleline Capital and manager of the firm's Total Return Bond Fund. Barron's magazine dubbed him the King of Bonds in 2011 and Mr. Gundlach is now arguably the world's most credible voice when it comes to interest-rate and bond yield forecasts.
Mr. Gundlach's current outlook is not good news for Canadian dividend and income investors.
In a Feb. 24 e-mail to clients, the manager predicted that the U.S. 10-year bond yield, now at 2.58 per cent, will fall to 2.25 per cent in the short term, and then rise to 3 per cent before the end of 2017. The first part of that forecast is great news for holders of dividend and income products. The lower bond yields go, the more attractive income-paying equities become, and the prices on these assets provide capital gains in addition to the regular payouts.
The latter portion of Mr. Gundlach's outlook, the 3-per-cent U.S. Treasury yield, is problematic. Canadian bond yields have historically moved in the same direction as Treasuries, even in periods when the two economies are moving in opposite directions. In the past 10 years, the average difference between domestic and U.S. 10-year bond yields has been a miniscule 17 basis points. If U.S. bond yields eventually go up, as Mr. Gundlach expects, investors should expect Canadian bond yields to follow.
Using the S&P/TSX REIT index as a proxy for income-related investments, the accompanying chart highlights the effects of changing bond yields on these sectors. The clear trend is that the future performance of REITs improves in accordance with the amount that the distribution yield exceeds bond yields.
Here's how the chart works. First, I calculated the spread – the difference between the yield on the REIT index and the yield on the government of Canada 10-year bond – at the end of every week in the past decade. Currently, for example, the yield on the REIT index is 5.7 per cent and the bond yield is 1.7 per cent – this makes the spread 4 per cent.
For each of those data points, I calculated the simple cumulative return for the index (not including dividends – there are boring data reasons why I couldn't use the total return REIT index) for the following 24 months.
Each dot on the chart shows the intersection of these two calculations or, in other words, the spread and the two-year REIT index return for every week since March, 2007.
The trend line on the chart slopes sharply upward. This means that the future performance of the REIT index improves with the amount it exceeds the bond yield.
Mr. Gundlach's prediction of 3 per cent Treasury yields, and the likelihood that Canadian bond yields will follow, means that the spread between REIT yields and bond yields will become smaller. The chart shows that REIT performance declines when this happens.
We can (very) roughly estimate REIT returns if and when U.S. bond yields climb to 3 per cent using a couple of assumptions. The 10-year government of Canada bond is currently yielding 75 basis points less than Treasuries. So, assuming that stays the case, the 10-year domestic yield will be 2.25 per cent when the Treasury bond hits 3 per cent.
We'll also assume the S&P/TSX REIT index yield stays the same at 5.7 per cent. The new spread at that point – REITs at 5.7 per cent and bonds at 2.25 per cent – would be about 3.5 per cent.
To estimate returns using the chart, we look for 3.5 per cent on the X-axis, move upward and check where that point meets the trend line. Then, trace that point on the trend line leftward to the Y-axis (forward returns), and see that this spread implies a simple cumulative return that is only marginally positive. This is not terrible once the dividend payments are added back in, but lower than investors in the sector have come to expect.
Again, this is only a loose estimate and one that's based on assumptions. Investors can depend, however, on the trend of rising bond yields limiting capital gains for equity-based income investments.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market online.