Why the 10 year bond rate matters

The most important number right now for professional investors is the 10 Year Bond rate.

The 10 Year Bond rate is an important anchor point for investors as a ‘risk free rate of return’ that is used in valuation models to calculate the value of assets including equities, property, infrastructure and fixed interest investments.

In short, lower bond rates result in higher asset values and by contrast, higher bond rates result in lower asset values.  Since 1994, investors have enjoyed the tail wind of falling bond rates, but the tide has turned since the last quarter of 2020 which has seen Australian 10 year rates rise from around 0.7% to around 1.7%.  That is a 140% increase.

In valuation terms, Arvid Streimann (Head of Macro, Magellan Financial Group)  says that a 1% increase in 10 year bond interest rates generally result in a 9% decrease in the capital value for 10 year bonds and around 15% for equities.

The factors influencing movements in bond rates according to Streimann are expectations of inflation and real economic growth.  Rising bond rates generally imply increased economic activity.  In recent times however Central Banks have artificially lowered long term rates through their Quant Easing (aka money printing) programs.

The chart below shows the difference in government bond prices for both a 1% and 2% rise in long term rates.

 Source:  Bloomberg

Investors in funds that are called ‘conservative’ or ‘stable’ usually have a high exposure to bonds and are at risk of loss from rising rates and would be wise to review these investments given the landscape has changed.

Streimann says that the impact of rising bond rates on the equities market is more nuanced.  He points out that equity valuations fall due to rising bond rates but not all equities are treated equally.  Those companies with higher levels of debt suffer a double whammy as they also receive a drop in earnings as they pay higher interest costs over time.  Vince Pezzullo (Deputy Head of Equities Perpetual) says that expensive growth stocks are more vulnerable to rising bond rates as they have distant prospective profits that are now discounted at a higher rate than before.

Pezzullo believes that if rising bond yields are signalling economic recovery, then cyclical exposed value stocks including energy, financials and mining, are likely to be beneficiaries as their business models have the most to benefit from the upswing in the economic cycle.  Streimann highlights the banks as a potential beneficiary of rising bond rates as they tend to earn higher rates of return on their loan portfolios which can boost profits.

The other issue for equity investors is that not all investors use the same bond rate when valuing assets, and some investors don’t use this valuation method at all.  Investors need to have an appreciation of the bond rate assumption being applied when reading research reports.

History generally doesn’t repeat itself unless people have forgotten about it.  The last time bond rate movements caused extensive market damage was 1994 which is a long time ago.  Pezzullo says the similarity to then and now is that markets were relaxed about the low inflation economic recovery, while the US Federal Reserve decided to push ahead with a surprise interest rate rise as growth accelerated.  During 1994, the Australian 10 year bond rate rose from around 6% to  over 10% resulting in short term damage to bonds and shares.

Streimann says the main difference between 1994 to today is the level and speed of communication courtesy of the internet, from the Central Banks.  It’s all about expectation versus reality and the Central Banks are articulating the economic indicators such as the unemployment and inflation rates required to be reached before raising rates.  This lowers, but doesn’t eliminate the probability of a bond market led panic.

Bond markets are currently stating that they believe Central Banks are likely to raise rates earlier and possibly higher than Central Banks have said on the back of an inflation scare.  The question is whether the Central Banks are willing to view an inflation scare a transient and leave rates low.  Investors would be wise to stay tuned to the communication coming out of the Central Banks for any changes in message.   Either way investors must prepare for an investment landscape with rising long term rates.

 

 

The article was written by Mark Draper (GEM Capital) and appeared in the Australian Financial Review on Wednesday 24th March 2021