- The war in the Middle East is driving up oil and gas prices and thus expectations for both inflation and central bank interest rates
- Central bank base rates influence the return available from asset classes such as cash and bonds
- The 10-year government gilt is seen as the risk-free rate and any other investment should return more than that to compensate for the additional dangers
- The higher the gilt yield goes, the less inclined, or obliged, investors may feel to pay up for alternative asset classes, such as shares (and vice-versa)
“The 2-year gilt yield is seen as a summary of financial markets’ views as to where the Bank of England base rate may go next on the principle that it takes 18 to 24 months for changes in the headline cost of borrowing to filter through to the economy and consumers’ pockets, but from an investment point of view it is the yield on the 10-year issue that really matters,” says AJ Bell investment director Russ Mould.
“The 2-year gilt is now warning of possible interest rate increases, while the 10-year gilt yield now exceeds the FTSE 100 dividend yield by more than one-and-a-half percentage points, and both are factors which help to explain the benchmark index’s retreat from its February all-time high.
Source: Refinitiv data
“Higher interest rates and bond yields in themselves do not necessarily spell the end of an equity bull run, but in the end, weight stops trains and racehorses and higher returns on cash and fixed-income securities slow down stock markets – it is a matter of degree.
“The FTSE 100 has done a good job of sweeping aside increases in the Bank of England base rate and the 10-year gilt yield from generational lows. In some ways, the increases were welcome as they signalled a normalisation of policy, a lesser threat of deflation and an environment where there was enough economic growth and inflation to perhaps support corporate earnings and cash flow, but not too much to raise the danger of overheating and rapid, and substantial, further increases in borrowing costs.
“But March’s surge in oil and gas prices after the start of the war in the Middle East has sparked concerns that a sustained increase in the cost of hydrocarbons could either slow the economy, stoke inflation or both.
“As a result, the 2-year gilt yield now comfortably exceeds the Bank of England base rate.
Source: LSEG Refinitiv data
“Meanwhile, the 10-year yield is hovering near the 5.00% mark for only the third time since 2008.
Source: LSEG Refinitiv data
“The test now is whether higher yields on government bonds tempt portfolio builders to take less risk and pay lower valuations and prices for riskier assets, because they may feel they do not need them quite so badly.
“Tales of investors ‘going to cash’ are entirely misleading. If someone sells, someone still must buy and give away their cash in exchange. The shares do not disappear, so there is no wholesale movement from one asset class to the next. Instead, there is a relative movement in intent and desire, as reflected in the higher or lower returns that the investor is prepared to accept in return for exposure to that asset class, be it cash, bonds, shares, or something else.
“Higher bond yields – by implication – have several possible implications for equity holders.
- First, higher interest rates as a result of higher oil and gas prices could dampen economic growth, or even lead to a slowdown or recession, and hit near-term corporate earnings, albeit in exchange for putting a lid on inflation and the long-term damage that causes.
- Second, higher interest rates and bond yields eventually feed into higher mortgage rates, and again potentially crimp consumers’ willingness and ability to spend and thus near-term economic growth, again potentially in exchange for the benefit of lower long-term inflation.
- Finally, as if pressure on corporate earnings and cash flows were not difficult enough for stock markets, there are two other issues. One is that increased bond yields can lessen the relative attraction of equities compared to fixed income as a source of yield. The other is that interest rates mean higher discount rates in discounted cash flow, or DCF, models. That in turn is potentially a particular challenge for the valuations attributed to growth stocks, such as technology companies.
The risk-free rate
“The yield offered by a government-issued bond is usually seen as the risk-free rate for investors in that country because, in principle, the government will not default on its liabilities. It will always be good to make the interest payments (or coupons) on time and return the initial investment (or principal) once the bond matures, even if it must print money to do so.
“Bear in mind that the yield on the bond will differ from the coupon, or interest rate, at its time of issue. This is because the bond’s price will move over time. The running yield of the bond is calculated by dividing the annual coupon by the current price and expressing that as a percentage. The yield to maturity will adjust for any capital gain or loss on after the purchase of the bond since it will usually be redeemed upon maturity at its issue price.
“The last time the UK defaulted was in 1672 with the Stop of the Exchequer under King Charles II and as such as the 10-year UK government bond, or gilt, is seen as the risk-free rate for UK investors.
“The 10-year gilt is yielding 4.91%. This is therefore the minimum nominal return on any investment that any investor should accept, since it is seen as risk-free (despite the tiny chance the UK does default, or the other challenges posed by movements in interest rates and inflation).
“Any other alternative investment carries more risk so the investor should demand more from them:
- Investment-grade corporate bonds should yield more than government bonds because companies can and do go bankrupt and management teams can do silly things.
- High-yield (or junk) corporate bonds should yield more than investment grade bonds because these firms are more indebted, and the risk of bankruptcy and default is higher.
- Shares should offer the prospect of higher total returns than junk debt because share prices go down as well as up, while a junk bond will offer pre-determined interest payments and return of the initial investment if all goes well.
“The returns demanded by an investor to compensate themselves for the (additional) risks involved will therefore, in theory, move relative to the gilt yield and that in turn will be influenced by central bank-approved interest rates.
“If a central bank is raising interest rates, then the yield on existing Government paper will look less attractive. Investors will sell them and look to buy newly issued gilts, which will have to come with a higher yield to attract buyers and help the Government fund its spending needs.
“This increase in yields on government debt means the returns that investors should demand from other, riskier options, should also increase. This means a higher yield on newly issued bonds or paying a lower price for existing bonds (as a lower price means a higher yield for bonds, just as it does for shares).
“For shares, it means paying a lower valuation, or multiple of earnings and cashflow, and perhaps demanding a higher dividend yield (which is achieved by buying at a lower share price).
“Remember that the total return from a share is determined by capital return plus dividend yield and the capital return will be, in crude terms, the function of both earnings growth and the multiple paid to access that earnings growth.
“In its simplest form, this can be seen in the price/earnings (PE) ratio. Earnings will go up (or down), depending upon the business cycle and the company’s target industry and acumen. The price, or multiple, paid can be affected by many things, including the company’s finances, managerial competence, and governance, as well as the predictability and reliability of its operations and financial performance.
“Interest rates will have a big say, too. If rates and gilt yields are rising, investors may feel less inclined or obliged to take more risk with shares and other asset classes if safer options are offering better returns, at least on a pre-inflation basis. As a result, they may decide to pay lower prices and multiples – a lower P for the E – and that is why stock markets can slide as rates rise, especially because someone still must hold the shares. They do not just disappear so the new owner must make a judgement on what they are worth.
“For property, the same calculation will apply – the rental yield will be benchmarked against the safer options, in nominal terms at least, of cash and gilts and other bonds. New buildings will need to offer a higher rental yield to attract buyers, and that often means lower property values.
The discount rate
“There is another way in which interest rate movements affect share prices and equity valuations and this is the more complicated version of the PE ratio. This is the discounted cash flow (DCF) calculation.
“Such a valuation approach is not necessarily suitable for, or at least easy to apply, to all companies, as some have business models and revenue and cash flow streams that are very volatile, or at least cyclical.
“DCFs tend to be used for companies that have relatively predictable cash flows, or long-term secular growth prospects. They are also used for young, early-stage firms that are seen as capable of generating profits some way out into the future.
“There are many moving parts to a DCF, including assumptions about the long-term operating margin, capital investment requirements, and terminal growth rate of a business, while a further key input is the assumed cost of the company’s funding (be it debt or equity) and the discount rate. The discount rate is used to value the future cash flows in today’s money, by discounting back those expected cash flows at a given rate.
“The greater the uncertainty over the value of the forecasts, the higher the discount rate and the higher interest rates and Gilt yields go then the higher the discount rate will, go too.
“And the higher the discount rate, the less the future cash flows will be worth in today’s money. That means a lower valuation for the equity and a lower theoretical share price, although the opposite holds true, too – the lower the discount rate, the higher the equity value and the higher the theoretical share price.
“This may be why a lengthy period of low or even negative bond yields prompted a huge uplift in the valuation of perceived growth companies, such as technology and biotechnology stocks, during the past decade, and especially in 2020 to 2021. Hopes for fresh rate cuts and drops in bond yields gave tech names such as the so-called Magnificent Seven another lift, along with a helping hand from investor enthusiasm for all matters related to Artificial Intelligence.
“The problem for holders of this sort of company is that the opposite effect is kicking in, at least for now and the example offered by 2021 to 2022’s slump in tech stocks as interest rates and bond yields rose is a cautionary one.
“The NASDAQ fell by more than a third from its November 2021 closing high of 16,057 to its low of 10,213 in December 2022 as the US Federal Reserve took the Fed Funds rate from 0.25% to 4.50% (and ultimately 5.50% by summer 2023) and bond yields moved up sharply as a result.”
