Watch out if long bond rates kick up ...

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 35-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 an average 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 an average of 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.

Article by Roger Montgomery:    (VIEW LINK)