There has been much discussion in the market this year regarding the rise in interest rates. It can be seen almost everywhere – The average 30-year fixed rate mortgage, which started 2022 at 3.11%, hit a high of 5.81% in June and currently sits at 5.51%. The 10-year US Treasury started the year at 1.51% and is now at 2.96% after reaching a high of 3.48%, and the federal funds target rate, has gone from 0.00-0.25% to 1.50-1.75%… to name just a few.
There are some that attribute a portion of the stock market’s fall this year to this rise in interest rates, a point we agree with.
It is generally believed that rising interest rates are bad for the economy because it decreases borrowers’ ability and willingness to take loans and therefore decreases those borrowers’ ability to spend or invest.
Rising interest rates, however, are bad for another reason, one that is less understood: Rising interest rates increase the discount rate applied to investments. The higher the discount rate, the less an investment is worth today.
Why do rising interest rates decrease the value of an investment?
First, it is important to understand that all investments are priced off of one another. Most commonly, you will hear an investment priced in comparison to the 10-year US Treasury bond (or maybe some other maturity treasury bond). For example, if a corporate bond has a yield of 5% and the maturity-matched treasury has a yield of 3%, it is said to have a “spread” of 2%. If treasury rates rise to 5%, that investor will now expect the corporate bond to yield 7% (to maintain the 2% spread), all else being equal.
But how does the yield rise to 7% for the corporate bond? Bonds have fixed payments set at issuance, the amount that will be paid in interest and principal will not change regardless of what happens to rates. The investor looking at purchasing the corporate bond can do nothing about how much is actually paid, so how can they now earn 7%? The answer is that the price of the bond needs to fall. If the bond was originally worth $1,000, an investor may now only be willing to pay $850 after the interest rate increase. The bond will still earn the same interest and pay the same principal, but now the investor will also earn an additional $150 if purchased at the $850 price. This additional $150 is what will help increase the yield, or the return, from 5% to 7%.
This dynamic works in reverse as well. If interest rates were to fall, bond prices will rise. This is why it is said that bond prices move inversely to interest rates. To be sure, this is certainly oversimplified. It is not always true that if US Treasury rates rise by 2% that the corporate bond will also rise by 2%. It may rise by more or less depending on the reason for the rate increase, but directionally this is correct.
What about stocks? If increases in interest rates decrease the price of bonds, should they also decrease the price of stocks? The answer is usually yes.
The problem is that unlike bonds, the correlation between rates and stocks is much harder to see. Bonds have fixed payments that are known before purchase. This allows an investor to calculate exactly what price they need to purchase a bond to get the yield they are seeking. Stocks on the other hand have uncertain cash flows, ones that are hard to predict and are dynamically changing with interest rates and the economy. For this reason, it is much harder to analyze a stock’s relationship to interest rates. However, just because the math is harder to do, it does not mean that the same principal does not apply.
When rates rise, it is said to increase the “discount rate” for stocks. Discount rate is to stocks, as yield is to bonds. It is synonymous with the expected return of the investment. When discount rates rise, the price of stocks should fall assuming there are no changes in cash flow, just as higher yields cause bond prices to fall.
The difference between the discount rate and US Treasury rates is called the “equity risk premium” and is similar to the “spread” we talked about above for corporate bonds. Like spreads, the equity risk premium is not a constant figure and will rise and fall with investor expectations and sentiment. Unlike spreads, however, there is no exact answer for what the equity risk premium is because it is based on estimates. Every investor may come up with a different answer based on their analysis.
A final point that is helpful to understand is that not all investments are affected by interest rate increases/decreases equally. The effect of interest rates on prices is directly related to how quickly an investment will be paid back. The longer it takes for an investment to recover its initial investment, the higher that investment’s sensitivity to interest rates. This sensitivity can be measured and is referred to as “duration.” The price of an investment with a duration of 5, for example, will increase (/decrease) by 5% if interest rates were to decrease (/increase) by 1%. A 5-year US Treasury might have a duration of 4, while a 30-year US Treasury might have a duration of 17 (I will not bore you with the math behind the duration calculation).
Stocks also have duration, but again, there is no “exact” duration of an equity investment because it is based on estimates of future earnings. Despite this, investors apply the same principle to stocks (or any other investment, such as real estate) as they do bonds – investments that will take a longer time to pay back (think tech stocks that are currently earning little to nothing but have high expectations for the future) will have higher durations and therefore more sensitivity to interest rates. This is one of the commonly cited reasons that tech stocks have performed so poorly this year.
