In the play, Waiting for Godot, the elusive Mr. Godot never shows up, which seems like a fitting metaphor for the ever-elusive rise in interest rates, which everyone (I know, not everyone) seems to be waiting for.
Featured below is a record of Google searches for the phrases “rising/falling interest rates” from March 2009 – September 2014. This isn’t a perfect record of searches on Google about interest rates–maybe the most popular searches on the subject used the word “yield” in place of “interest rates”–but it’s probably pretty close.
Let’s use a trick of economists for a moment and cry ceteris parabis, or all else equal. We’ll assume that I’ve used pretty good–wait, we’re economists; let’s say the best–representations for searches on the direction of interest rates. There’s a lot of stuff on this graph that we won’t delve into here; for example, the peak search for rising interest rates was in June 2013, at the time of the so-called “Taper Tantrum,” would former Fed Chairman, Ben Bernanke, suggested the Fed might taper its bond purchase program.
Whatever else might be said, what’s on people’s minds is rising interest rates and not falling interest rates. You can see that by doing your own Google search of the phrase “rising interest rates,” where you will see stories from major news outlets, alongside stories from non-traditional media like blogs about rising rates.
For a moment, let’s put aside the fact interest rates appear to still be in a downward trend, as evidenced by this chart of the 10-year Constant Maturity Treasury Rate, courtesy of the St. Louis Fed.
For that moment let’s take a look at what rising interest rates might mean to you.
While there are probably other ways rising interest rates might affect you, four come to my mind. Here they are in brief, and I take them up in greater detail below.
Higher interest interest rates…
- Lead to bond prices declining;
- Make bond yields relatively more attractive than stock dividend yields;
- Reduce the value of potential future cash flows; and
- Raise the cost of companies doing business via higher interest expense.
Higher interest rates lead to bond prices declining
Take a world in which there is one interest rate and only one kind of bond available; it’s a five-year bond. Today (day 1) it has an interest rate of 5%, and it’s selling for $100 per bond. If you buy that bond today, and tomorrow (day 2) the same bond sells with an interest rate of 6%, is the bond you bought worth more or less? Less, of course.
Higher interest rates make bond yields relatively more attractive than stock dividend yields
Imagine that, on day 1, ABC stock has a dividend yield of 2.5% and XYZ bond has a yield of 2.0%. On day 1, all investors interested in income would–all else equal–prefer ABC stock. On day 2, if the yield of XYZ bond had risen to 2.75%, all of those investors would prefer the XYZ bonds, and they might sell their ABC stock to buy the XYZ bonds. That will push the price of ABC stock down.
In the real world, where things aren’t so binary, these sorts of changes in preferences happen at the margin, and only certain investors would make the switch.
Think of the market for new cars, like when a manufacturer introduces its latest version of a particular model. While owners of the current model might wish they’d waited to buy, it’s likely that only folks in the market for a new car at the time will buy the new model. That’s the notion of marginal activity. It happens at the edge, while the core doesn’t [yet] change.
Higher interest rates reduce the value of future cash flows
Let’s say you have a machine that produces the world’s best donuts, and the donuts sell for $1 each and produce a profit of $0.10 each. If you sell 100 donuts every day, and the machine lasts for 10 years, after which it goes to the scrap heap, worth zero, then the lifetime profit of the machine is $36,650 (100 x $0.10 x 365 x 10.) Unfortunately, the $10 you earn on day one of year nine is not worth what $10 tomorrow is worth. There are several factors that go into this, not the least of which is inflation.
So we need to determine the present value of all that cash we receive. To keep things simple, we will assume we get the cash at the end of each year–totally unrealistic, but it will work for our example.
To determine the present value of a stream of cash flows, we must have a discount rate, which can approximate an interest rate. Let’s use 5% in the first case. The present value of all the cash profits received from the machine is $28,184. If the discount rate goes up to 6% because interest rates rise, the value will fall to $26,863. (To learn more, Google the phrase “present value of an annuity formula.”)
Owning a stock is no different. The value of a stock is the present value of all the dividends received over the holding period plus the sale proceeds when the stock is sold.
Higher interest rates raise the cost of companies doing business via higher interest expense
Following on the heels of the earlier example, it’s easy to see how this is the case. Imagine that, in the case of our donuts, our profit accounted for $0.01 of interest expense per donut (i.e. the $0.90/donut included a penny of interest expense). If interest expense doubles, then our profit per donut falls to $0.90, and the compound effect of higher interest costs and a higher discount rate (from 5% to 6%), is to reduce the value of our machine from $28,184 to $24,712.
There is, however, a silver lining to the cloud of higher interest rates, and it’s comprised of these factors, if not more.
1. Folks living on a fixed income–think of a retiree depending on interest from CDs–likely face higher future income, but that has to be considered in light of #1, above, the fact that bond prices fall when interest rates rise. So our retiree may suffer a hit to the market value of his/her fixed income investments.
2. There is an offsetting factor to #1, above, and that’s that bond prices include a reinvestment rate, the rate at which interest (coupon) payments are reinvested, and with the reinvestment rate presumably rising, the effect on bond prices is somewhat limited. Large endowment portfolios enjoy this effect when they are able to reinvest interest and dividend payments until they’re needed.
Still, all in all, and with everything else equal, rising interest rates are not what investors should hope for. Things one can do in an investment portfolio to prepare for rising interest rates will be addressed in a later post.
Graig P. Stettner, CFA, CMT
Strategence Capital, LLC
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
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