In recent months, interest rates have been rising globally, exerting a downward gravitational pull on the value and price of most assets. It’s a trend that’s likely to play out for some time.
An investing truth
A simple rule to remember when it comes to investing is this: the higher the price you pay, the lower your returns. If, for example, a non-dividend-paying company’s shares are going to trade at $20 each in November 2028 – ten years from now – then paying $5 for them today will deliver you a 15 per cent compounded annual return. But paying $10 for those shares today will only deliver you a 7 per cent annual compounded return. It really is that simple, the higher the price you pay the lower your return, and the lower the price you pay the higher your return.
Flipping this idea, if we know that a business is going to generate $20 of cash flow for us in November 2028, what is that future $20 worth today? The answer depends on the rate we use to ‘discount’ that future cash flow back to today. If we demand a 15 per cent return on our investment over the next ten years, the value of that $20 in the future is worth $5 to us today. If, however, we are satisfied with a seven per cent annual return on our money, then that future $20 is worth $10 to us today.
See what we have done there? By lowering the rate of return we require from our investment – from 15 per cent to 7 percent in the example above – we have increased the present value of a future cash flow – from $5 to $10. In other words, when interest rates (required returns) fall, the value of an asset rises. The reverse is also true. In our example above, if interest rates were to rise from 7 per cent to 15 per cent, the value of that future $20 falls from $10 to five dollars.
As interest rates rise, asset values fall. And that applies to all assets – businesses, shares, property, land, everything that produces income. All you have to remember is that rising interest rates affect asset values the way gravity affects everything on Earth.
And as the value of income producing assets fall, banks are less inclined to lend, which reduces liquidity, reducing money available to speculate on non-income producing assets such as art, wine, cars and low digit number plates.
The change to Quantitative Tightening
2018 is proving to be a transition year. While US Ten Year bond rates have been rising for more than two years, from a low of 1.36 per cent to more than 3.2 per cent today, the market only appears to have received the message this year. The one-year forward price-to-earnings (PE) multiple of the S&P500 has fallen by 17 per cent this year. That’s big. In the GFC year of 2008, the PE ratio compressed by 18 per cent.
Consequently, and especially if rates keep rising, those investors who paid record prices for everything from property to collectibles could now experience poor returns. The only question is whether those lower returns are accompanied by higher volatility than what many have become accustomed to.
So how did we get here? Quite simply, Quantitative Tapering, followed by Quantitative Tightening (QT), not only by the US Federal Reserve but also by the European Central Bank (ECB) and the Bank of Japan (BoJ) has affected bond demand and supply, crowded out corporate bonds and triggered a funding squeeze for the banking system.
Meanwhile, US Libor rates, now well above 2 per cent, have pushed the US cash yield above the global aggregate bond yield for the first time since 2008.
Consequently, the yield has risen, and prices fallen, in equities and bonds.
The US Federal Reserve has been on a path of reducing the size of its balance sheet. That means that instead of buying government bonds, increasing the size of its balance sheet, and injecting cash into the banking system (Quantitative Easing), the Fed has been tapering its purchases (QT). In other words, the world’s biggest buyer of bonds over the last ten years, has stopped buying and will begin to sell. And investors must understand that this is not a ‘cyclical’ change – a change that will revert back– it’s a ‘structural’ one.
Additionally, President Trump’s larger budget deficits – you know about the corporate tax cuts in America – need to be funded with bond issues which are adding to supply of bonds.
So, what we have today is more US bonds being issued by the US Treasury at a time there is less bond buying by central banks. Meanwhile, the ECB and BoJ are also reducing/tapering their demand for bonds. When supply goes up and demand goes down, bond prices have to fall, and consequently bond rates have to rise.
Back when the US Federal Reserve was buying all of those US Treasury Bonds, investors wanting a better yield had to invest in bonds issued by US corporates. Consequently, the corporate bond market boomed. One consequence of the boom was the spread between US Treasury Bond and US CCC-Rated ‘Junk’ Bond narrowing to just 3.15 per cent. In other words, so desperate for yield were investors they were willing to lend money to the riskiest companies at just 3 per cent above what they were willing to lend money to the materially safer US Government.
But now, with the Fed reducing its bond buying and with the US government issuing more bonds to fund its deficits, the higher yields on government bonds are starting to look more attractive.
Consequently, investors who were overweight corporate bonds are selling those bonds, pushing their yields higher too. You can see this in the market value of Corporate Bond ETFs such as the iShares IBoxx US Dollar Investment Grade Corporate Bond Fund (NYSEARCA: LQD), which has fallen from more than US$116.00 to US$111.00 since August.
Arguably more meaningfully, the switch from US Corporate Bonds to US Treasuries – and the resultant higher corporate yields – is occurring at a time when a record 47 per cent of all US Corporate Bonds are rated the lowest BBB investment grade, and 14 per cent of S&P1,500 companies are considered ‘zombie’ companies unable to pay their interest from earnings before interest and tax.
I would not be surprised, as interest rates on these bonds rise, that the high levels of leverage, results in a significant number of downgrades to these BBB bonds by the ratings agencies.
Perhaps even more worryingly, a credit market record level of CCC-rated High Yield (Junk) debt is due to be refinanced in 2019 and 2020.
When bond ratings fall
When companies on the edge of being financially viable see their bond ratings fall and their interest rates rise, they start laying off staff or go under. This is something that the stock market would take a keen interest in. As the market casts its shadow before it, the time to be concerned is probably now.
Plenty of high-profile investors globally have warned the champagne years for asset prices are behind us. With lower returns expected for aggregate benchmarks such as the S&P500, it is now more important than at any time in recent years to employ caution to one’s investing. Now is the time, if there ever is a time, to pursue strategies and managers that emphasise the preservation of capital rather than full participation in rising markets.
Even if sentiment causes market prices to rise in the next few months, the structurally changed stance of global central banks means that asset valuations are heading in the opposite direction.
And that brings us to cash. Back in the ‘recession we had to have’ cash was king. Recently cash became a liability earning punitive returns that nobody wanted. But cash is most valuable when nobody else has any. That time, when cash is most valuable, appears to have arrived.