Arguably the greatest risk to investors today is an underappreciation of how significant a change in bond interest rates will be. And these rates can change even if central banks don’t raise their own short-term offerings. So discussions about what the US Federal Reserve bank does with the fed funds rate, or the Reserve Bank of Australia through its own open market operations, aren’t particularly helpful.
The rates I am referring to are the long-term rates that are a cornerstone variable in the macro economy and are typically set by market forces, through inflationary expectations and variations to perceptions of a sovereign’s relative risk.
Long bond rates are important. They are a key variable in a borrower’s decision to commence a business or acquire a property. Policy makers gauge the state of the economy, and government expenditure financing is decided upon, using long-term rates as a benchmark. Lenders also use long bond rates as the benchmark against which they weigh the risk against the reward of extending credit. Perhaps most importantly, however, the long-term bond interest rates are the rates used to estimate the value of assets and projects.
All-time lows
The GFC ended a credit-fuelled asset boom, and an aggressive global policy response pushed long-term interest rates to epochal lows. Today, the US 10-year rate sits below any level since the 1700s and below rates observed during the Great Depression. Elsewhere, more than a third of the world’s sovereign bonds are trading at negative interest rates (if you lend one of these governments your cash for 10, 20 or 30 years, they will repay you amount less than what you invested at the end of the term) and more than 80 per cent of the world’s sovereign bonds are trading at rates lower than 1 per cent.
This recent world of low interest rates and low rates of returns has been described as the ‘new normal’. I always worry when new names are given to describe market and economic conditions. It’s tantamount to saying ‘this time is different’. This time is rarely if ever different and signs are already emerging that the 30-year decline in long-term interest rates may be ending. And if long bond rates do reverse, the repercussions for investors will be very serious.
How rates impact valuations and projects
An asset – any asset – is only worth the present value of the net cash flows that can be extracted over its life. To arrive at the present value, one must discount the future cash flows back to today. This is because $100 received in 10 years’ time, for example, is not worth $100 today. It is worth something less. How much less depends on the discount rate one applies, to the future $100, to arrive at today’s value. The higher the interest rate, the lower the present value.
For example, $100, to be received in 10 years’ time, discounted to today using a 2 per cent rate, is worth $82.03. When the discount rate adopted is raised to 10 per cent, that same $100 in 10 years is only worth $38.55.*
The discount rate used by investment decision-makers is influenced by the rates of return that can be achieved elsewhere, starting with sovereign. If government bond rates begin to rise, so will the discount rate used by investment managers and corporate chief financial officers.
As you can see from the above example, an irrefutable inverse relationship exists between asset values and interest rates. As interest rates go up, the value of an asset and the returns from a project fall. And it doesn’t matter whether that asset or project is farmland, a business, shares, bonds or a commercial property. Interest rates act like gravity on the value of assets. The higher the interest rate the stronger the gravitational effect.
20 years of extraordinary returns
Remembering the equally irrefutable investing maxim ‘the higher the price you pay, the lower your return’, we can actually see the influence of interest rates on the returns from the stock market over long periods of time.
Between 1960 and 1981, interest rates in the US surged, and along with the equity market risk ‘premium’, rates rose from circa 5 per cent to 18 per cent. Over that 20-year period, the S&P500 index returned just 3.6 per cent per annum. That’s 20 years of low returns.
Then, between 1981 and 2000, interest rates plunged, sending the combined US bond rate and implied equity risk premium back down to 8 per cent. In that 20-year period, the S&P500 returned almost 15 per cent per annum. Twenty years of extraordinary returns.
Since 2000, the combined rate has been flat and, perhaps surprisingly, the S&P500 has returned just 2.5 per cent per annum. Another 16 years of low returns.
As interest rates initially decline, they push up asset values, which are followed by asset prices. But once asset prices are already high, returns suffer. More importantly, as interest rates rise, asset values and prices fall, pulling returns down with them.
Another way to think about the mechanism through which asset prices are adjusted when interest rates rise, is to ask a room full of investors whether they might sell their shares if term deposits rates were today offering 7 per cent per annum. A very large proportion of investors are looking to sell stocks in favour of cash in the safety of a bank term deposit.
In Part 2 of this column we move on from the theory and examine what is presently occurring, while answering questions about where the risks and opportunities exist.
* This article was edited on 29/9/16 to correct calculations.
