However, in reality, there are important differences between bonds and REITs that investors need to understand when deciding what asset allocation is right for them.
Let's take a look at what these differences are, the pros and cons of each kind of asset, and most importantly, what the right mix of bonds and REITs is reasonable for a retirement portfolio.
Most Important Differences Between Bonds and REITs
The most important difference between bonds and REITs is that bonds are fixed-income investments issued by governments and companies that pay a set coupon (interest rate), usually once every six months.
These payments are typically fixed and thus the value of a bond (which trades daily on the bond market) is largely a function of time to maturity and prevailing interest rates (both long-term Treasury yields and rates on similar bonds being issued today). Bonds have a limited lifespan because they eventually mature.
The other important thing to know is that bonds have a higher priority in the capital stack, which is comprised of the total capital invested in a business (common equity, preferred equity, mezzanine debt, and senior debt).
In other words, bond investors get preferential treatment in terms of repayment in the event that the bond issuer experiences financial distress. That's why bonds have relatively lower risk.
REITs are perpetual investments that have no maturity date and can theoretically continue to exist and grow their asset bases for decades. Unlike bonds, REITs tend to pay rising dividends over time as their cash flow grows, and thus tend to have offer better capital appreciation potential than bonds.
Advantages and Disadvantages of Bonds
Since 1900, both on an absolute and inflation-adjusted basis, equities (including REITs) have vastly outperformed bonds as well as cash equivalents like short-term Treasury bills.
Not only do bonds generate fixed income, but they tend to be much less volatile than stocks and have historically had very low correlations with stocks. For instance, between 1928 and 2017 the correlation between stocks and bonds was just 0.03, meaning that these two asset classes traded almost completely independent of each other.
The benefit of such low correlation is that owning some bonds can drastically reduce your portfolio's overall volatility, especially when the stock market experiences one of its inevitable bear markets.
This is why the default recommendation for most retirement portfolios (once you are already retired) is 60% stocks and 40% bonds. Such a portfolio has historically captured much of the upside of a 100% stock portfolio but with far smaller declines during years when stocks crash.
1974 and 2008 have been the worst years for stocks since World War II and provide good examples of the stability bonds can provide:
- 1974: S&P 500 lost 26.5% (60/40 portfolio declined 14.7%)
- 2008: S&P 500 lost 37.0% (60/40 portfolio declined 13.9%)
Bonds, which tend to appreciate during market declines (flight to safety and falling interest rates), are thus a good way to smooth out your total returns while still typically enjoying a healthy rate of compounding.
Historically, a 60/40 stock/bond portfolio has captured the majority of a 100% stock portfolio's total returns while significantly reducing a portfolio's drawdowns.
While historical data is a useful guide to making long-term investment decisions, it's important to keep in mind that bond returns over the last few decades were boosted by an interest rate environment that is unlikely to persist in the future.
Specifically, between 1981 and 2016 the benchmark 10-year Treasury yield declined steadily from a high of nearly 16% to its lowest level in history (1.4% in July 2016).
Bond prices move inversely to interest rates, so this asset class enjoyed a 35-year secular bull market that greatly benefited fixed income investors over most of our investing lifetimes.
The yield on a 10-year Treasury sits near 3% today. Since interest paid by these bonds is taxable at the Federal level, their after-tax yield is roughly 2.5%. And if the Federal Reserve successfully hits its 2% annual inflation target, then the after tax return, adjusted for inflation, on these long-term bonds would be about 0.5% per year.
As Buffett said, long-term bonds at these rates are “ridiculous.” Investors thinking about buying long-term bonds need to keep this in mind, especially as they look at historical returns of various retirement portfolio allocations.
Future bonds returns are unlikely to come close to what they delivered in past decades. Therefore, playing too conservatively by investing heavily in long-term bonds could result in a nest egg not lasting long enough to cover a full retirement given its lower returns.
Advantages and Disadvantages of REITs
Unlike bonds, which pay a fixed amount of interest and have a set maturity date, REITs are productive assets that can increase in value indefinitely. As these businesses profitably acquire more properties, they grow their cash flow, can increase their dividends, and see their stock prices appreciate over time.
Similar to bonds, the performance of REITs can be sensitive to interest rate fluctuations over the short term. However, since these are productive assets that can grow their cash flow over time, interest rates are less of a factor in the long term.
In fact, Standard and Poor's published a study reviewing the impact of rising interest rates on REITs. The firm stated that “when expectations about future interest rates change suddenly, REITs have often experienced high volatility and rapid price changes.”
“Ultimately, whether interest rates are rising or falling does not seem to be the key driver of REIT performance over medium- and long-term periods. Rather, the more important dynamics to address are the underlying factors that drive rates higher. If interest rates are rising due to strength in the underlying economy and inflationary activity, stronger REIT fundamentals may very well outweigh any negative impact caused by rising rates.”
Furthermore, since 1972 equity REITs (the ones that own commercial rental properties) have outperformed all three major stock market indexes. That's despite high and rising interest rates in the 1970s and early 1980s.
In fact, since 1972 the correlation between the benchmark 10-year Treasury yield and REIT total returns has been just 0.04 (effectively zero). This shows that, while REITs can be sensitive to long-term interest rates in the short term, over the long term this sensitivity cancels out.
- Global REIT inflation-adjusted total returns: 6.4%
- Global stock real returns: 5.5%
- Non-government bonds: 3.5%
- Government bonds: 3.1%
In every single decade, REITs outperformed stocks, and typically bonds as well. And that's across a wide variety of economic, industry, and interest rate environments.
First, the very thing that makes this such a high-yielding sector, the requirement to pay out nearly all taxable income as dividends, also means that REITs are highly dependent on external capital markets to fund their growth.
Specifically, since very little cash flow is retained to fund new property acquisitions, growing REITs must frequently issue equity and debt to keep their businesses growing. Buying real estate is not cheap, so REITs are generally highly leveraged.
Given the long-term nature of REIT leases and their stable cash flows, this isn't usually a major risk factor. However, in the event that credit markets collapse (as happened during the Financial Crisis), REITs with weak balance sheets can be forced to cut their dividends, even if their cash flow covers their payouts.
As you can see, certain types of REITs held up better than others. Defensive areas like self storage and healthcare held up the best in 2008. However, each REIT subindustry was hammered compared to Treasury bonds, which actually gained in value during the financial crisis.
Simply put, REITs are more vulnerable to market selloffs than bonds. Fortunately, REITs today have the strongest collective balance sheets in their history, according to data from NAREIT and Hoya Capital Real Estate.
In other words, barring an even worse Financial Crisis in the future, more REITs will presumably be able to maintain or even grow their dividends even during future economic downturns and bear markets. However, there is another important disadvantage REITs face that you need to be aware of.
Blue-chip REITs that are conservatively run are able to adjust their capital raises to continue growing their property bases, cash flow, and dividends, in all manner of share price and interest rate environments.
For example, during REIT bull markets, when share prices are high and cost of equity low (making equity raises more accretive to cash flow per share), REITs sell more shares. During bear markets, they turn to low cost, fixed-rate bonds to fund their growth.
When REITs are out of favor, their low share prices create high costs of equity that can make profitable growth challenging, and in some cases impossible. And since new REITs tend to IPO with high dividends (to attract investor interest) they can take several years to grow into their dividends and bring their payout ratios to safe levels.
Thus conservative income growth investors typically want to stick with large, well-established REITs that have strong access to low-cost growth capital and solid long-term dividend growth track records.
What's the Right Mix of REITs and Bonds in a Retirement Portfolio?
REITs are a kind of equity, so the right way to think about them isn't as an alternative to bonds (REITs are not "bond proxies" over the long term) but rather what percentage of your stock portfolio should be in REITs.
Again, the right amount of REIT exposure depends on your individual goals, risk tolerances, and portfolio size, among other considerations. However, a good rule of thumb we like to follow is that no single sector should represent more than 25% of your equity portfolio. That's to ensure that, in the event of an extreme historical anomaly (like REITs getting clobbered during the Financial Crisis), your income and stock portfolio avoid suffering a disaster.
Closing Thoughts on REITs vs. Bonds
REITs are a form of equity (stock) that should continue enjoying total returns that are superior to bond returns over time while also doling out higher amounts of current income. When you buy shares of a REIT, you own a perpetual stake in an expanding real estate operation that hopefully pays steadily rising dividends as it grows in value over time.
While both REITs and bonds have enjoyed lower volatility compared to stocks, bonds are the lower volatility asset class due to their much lower correlation with stocks. Meanwhile, REITs can experience significant share price volatility, especially over short periods of time. Their dividends are also not as safe as bond coupon payments over a full economic cycle.
In general, a good rule of thumb is that REITs should not make up more than 25% of a well-diversified dividend stock portfolio, depending on your individual goals (such as what portfolio yield and long-term dividend growth rate you're targeting, and how much volatility you can stomach).
And as always, the primary focus of conservative REIT investors should be on maximizing safe income, rather than taking on excessive risk by reaching for yield in stocks with potentially unsustainable dividends. Our Dividend Safety Scores can help investors sidestep stocks with the riskiest payouts.