Macro Economics

Interest Rates – An important indicator is moving

Posted

– Post from December 2016 –

University Finance 101 teaches students an important fundamental investing concept – the time value of money. That is, one dollar in your hand today is worth more to you than one dollar in your hand in one year. Why? Because you can invest the one dollar in your hand in the interim.

As investors, we allocate capital in order to generate cash flows in the future to maintain or increase our purchasing power. A critical step in this process is determining the rate at which to discount any expected future cash flows to the present day in helping determine the appropriate price to pay – often referred to as a discount rate.

From a risk to capital perspective, a Government Bond is generally viewed as risk-free investment. Given investing in other assets involves risk, investors typically use the 10-year Government bond yield as a floor in their discount rate to value the future cash flows of alternative investment options.

Assume the Australian Government 10-year bond yield was 2.5% and a business was expected to generate $1 of earnings per share (all paid out to shareholders) in twelve months’ time.

Given there is greater risk to capital investing in a company’s equity compared to a government bond, let’s adopt a risk factor into the discount rate used and ascribe a 5% risk premium to compensate us for the risk which, when added to the 10-year bond yield, equates to a discount rate of 7.5%.

How much would we be prepared to pay for the $1 in earnings with a 7.5% discount rate?  The most we would pay is $13.33 per share ($1 / 7.5%)

Now, let’s assume that bond yields increased to 3.5% creating a new discount rate of 8.5%.

How much would we be prepared to pay for the $1 in earnings with an 8.5% discount rate?

The most we would pay for the $1 in earnings would now be $11.76

In this instance, a 1% rise in the bond yield has resulted in an 11.74% loss on the investment. This is a critical concept for any investor to understand particularly in light of recent activity in global bond markets.

For over 30 years, global bond yields have declined steadily. The graph below shows the US bond yields since 1981.

  US 10-Year Government Bond Yield (1981 to 2016)

 

It is not surprising to see that as interest rates have declined, financial asset prices such as property and shares have risen.

However, as the graph below shows since July 2016 global bond yields have risen sharply. US bond yields were trading at just less than 1.4% in early July but are now 2.2%.

US 10-Year Government Bond Yield (January 2016 to November 2016)

In Australia, our bond yields hit 1.93% in early August and at the time of writing were 2.77%. These may not seem like big movements but the simple example above gives some insight into the impact relatively small movements in bond yields can have on capital values of certain assets.

It is of no coincidence that the share price of interest rate sensitive businesses such as APA Group, Transurban and Westfield Corporation hit highs in July and are now down by over 25.5%, 22%, and 24.5% respectively. This can largely be put down to the change in global bond yields.

Our approach to individually managing our clients’ investment portfolios is to focus predominantly on finding great businesses trading at sensible prices. We believe this is a far more practical approach than buying a business based on having to accurately predict macroeconomic data points such as interest rates, currency and GDP movements. The latter is an approach fraught with danger and not an approach we have seen anyone apply with consistent success.

However, while we do not bother ourselves with trying to predict the next economic data point, we do stay abreast of longer-term macroeconomic trends in order to ascertain their impact on the business we own and the businesses we are looking to buy.

We do not know if the movements in the bond market since July are a reversal of the longer term downtrend in yields or a temporary jump, however, the movements certainly have our attention.