Interest rates are one of the two most important variables that affect investment results. The other is profitability. The value of any investment—whether it be bonds, stocks, real estate, the value of a business or whatever—is altered when interest rates change.
In Finance 101, one of the first things students learn is the present value formula: The value of any investment is the sum of all the future cash flows it produces discounted to present by the appropriate interest rate.
When interest rates rise, those future cash flows are worth less since they are discounted at a higher interest rate, which yields a lower present value. And vice versa: When interest rates fall, future cash flows are worth more at present, and investment values increase.
The effect of an interest rate change is evident in the formula for bond pricing, where the interest rate is fixed and the cash flow received at maturity is known. Bonds and other fixed-income investments are rightly called interest-sensitive securities.
On the other hand, the effect of interest rate changes is usually obscured in the valuation of stocks, real estate and other assets where there are other factors at work. The prices of these assets can be affected by market psychology, which can send valuations lower than they should be when investors are depressed, or higher than fair value when buyers are giddy. In addition, the cash flows that accrue to a stockholder from the underlying business will fluctuate and occur irregularly. The same goes for a piece of property. Nevertheless, the tug of interest rates is always there.
So when the government talks of changing the level of interest rates, investors begin to factor this change into their thinking with regard to the intrinsic values of their investments.
For example, at current interest rates, quality companies might deserve price-to-earnings ratios of 18 or more. However, were the 10-year government bond rate to rise from 2.25 percent to 4 percent, perhaps a lower PE ratio of, say, 15 is justified. In this example, the present value of one dollar in future corporate profits, other factors being equal, would have declined about 17 percent solely due to the rise in interest rates.
You can also think of interest rates as a sort of “hurdle rate” for investments. In other words, if the interest rate on government securities rises to 4 percent, an investor will need to find opportunities that can earn returns demonstrably higher than this hurdle rate, particularly when you consider the risk factors involved. Otherwise, a 4-percent return, essentially risk-free, would be satisfactory.
One winner in a rising-interest-rate environment is pension funds. As rates rise, the liability side of their balance sheet falls in value. Higher interest rates decrease the future value of the cash flows that must be paid out to pensioners. Offsetting this benefit, the pension fund would suffer losses on the asset side of their balance sheet if they hold a sizable bond portfolio.
The effect of interest rates on investment valuation is unmistakable. It appears the United States is on the precipice of a change in interest-rate policy. Investors will need to factor these changes into a review of their portfolio.•
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or firstname.lastname@example.org.