How retail investors can take advantage of high rates

Last week, I said buying bond funds might be a good way for investors who don’t have a large enough portfolio to participate in the favorable outlook of bonds next year.

Although I still think that bonds will perform well next year, I’m now less keen about investing in them after analyzing the local bond funds that are available in the market.

The devil is in the details and the main reason why I’m not as excited about buying bond funds is their short duration or the concentration of their portfolios on bonds that will mature in less than three years.

Having a bond portfolio with shorter maturities is good when interest rates are rising because that would reduce volatility. However, when interest rates start to fall, which is what we expect to happen next year, potential returns will also be limited.

For example, if interest rates drop by one percentage point next year, a portfolio that is concentrated on 10-year bonds will enjoy a capital appreciation of around 10 percent, while a portfolio that is concentrated on 2-year bonds will only enjoy a capital appreciation of only 2 percent.

Moreover, given the small size of Philippine bond funds, expense ratios are very high. This also reduces potential returns for investors.

For example, based on the list of bond funds available in COL Financial’ s fund distribution platform, bond funds’ expense ratios typically range between 1.5 percent and 2 percent. Although the yield of 2-year bonds is now very high at 6.07 percent, stripping out the 20-percent withholding tax on the coupons and the 1.5 to 2 percent management fee, the bond fund’s potential return to investors would drop to only 2.8 percent to 3.3 percent.

Admittedly, returns could potentially be higher if the market rate for the 2-year bond goes down. However, as mentioned earlier, capital appreciation potential is capped by Philippine bond fund portfolios’ short duration.

There is also a risk that the yield on shorter term bonds won’t drop even if inflation goes down next year since the Bangko Sentral ng Pilipinas said it would match the Fed’s future rate hikes “point for point.”

Note that although longer term bond rates are sensitive to inflation expectations, shorter term bond rates are more sensitive to central banks’ rate adjustments. This explains why the yield curve in the United States is now inverted, with the yield on the 2-year bond higher than that of the 10-year bond.

If you don’t need liquidity in the short term and can afford to hold on to fixed income securities for a few years, a good alternative to bond funds is retail treasury bonds (RTBs) that are issued by the Bureau of Treasury twice a year. RTBs have varying maturities of 3 to 5.5 years, while yields are competitive.

For example, the yield on the latest 5.5 year RTB offered in August reached 5.75 percent. The good news is, you can subscribe to these RTBs for as little as P5,000. The main drawback is you can’t trade these bonds or sell them when you need liquidity.

Another option for investors who would like to take advantage of the high yields prevailing right now is to buy REITs.

Given the significant decline in their prices brought about by the sharp rise in interest rates, the average dividend yield of Philippine REITs for 2023 is now estimated to be 8.5 percent.

Although there are concerns regarding the ability of REITs that are focused on office properties to maintain their high dividend yields due to the various challenges facing the office leasing segment, there are non-office related REITs available such as CREIT that is focused on power.

The good news is these REITs can be bought for only a few thousand pesos in the PSE. Moreover, their dividends are taxed at a lower rate of 10 percent vs 20 percent for bond coupons. The catch is REITs have no maturities, so you can lose money in case the company you choose suffers from lower lease rates or higher vacancies, or you need to sell your investment at a bad time. INQ