Tuesday, 9 August 2011

Investing Risk: The Harmful Effect of Rising Required Rate of Return

In this last post of our series on the most important investment risks, we examine how much the required rates of return on investments varied in the past. It may seem odd to call the rate of return a risk since return is the reward for investors. The problem is that if required return rises, the price of the investment asset will fall. For example, in order for a bond that has a fixed interest coupon rate to provide a new higher return, the price of the bond must be lower so that the bond provides a capital gain in addition to the fixed interest received. The existing bondholder experiences a capital loss. Similarly, stocks with given earnings and dividends must fall in price to provide capital gains to reach the higher required return.

The Rise and Fall of Required Returns - Required returns do not stay constant. Through the years there has been much variation. In the chart below from Retail Investor, we see that yields of all maturities of fixed income have fallen steadily since the early 1980s. That trend continued through the mid 1990s to today, despite the fact that inflation has remained consistently in the Bank of Canada's 1-3% target range throughout. This illustrates the important point that required returns in the form of interest rates can vary independent of inflation.

What has come down once went up. From the 1930s to 1982, interest rates and yields followed a general upward trend, as illustrated by this chart of US Treasury Bill rates since 1920 from the Gold versus Paper blog. Within that trend however, there was significant variation through the decades.

To those who may think that the current ultra low interest rates are due to rise soon, this chart shows us that near-zero-rates persisted for about a decade during the 1930s.

Similar Canadian historical rates for Federal Government T-Bills and Long-Term bonds can be found at the Bank of Canada here.

Several lessons stand out for the investor:
  • rates have varied from virtually zero to over 20%
  • upward and downward trends have persisted for several decades
  • spikes and dips of 5% or more within a couple of years have often occurred within the longer term trend; those spikes will hurt!
The Current Situation of Required Returns

1) Bonds and Fixed Income - In the case of bonds or other fixed income investments like Treasury Bills and GICs, the current required return is easily visible. It is the current yield found on websites where current market fixed income quotes are available - such as GlobeInvestor, CanadianFixedIncome.ca, or any online broker. For example, the Canadian Federal Government bond maturing 1 June 2037 with a coupon rate of 5.0% yields only 3.31% as of August 2nd according to GlobeInvestor. T-Bills are now yielding around 0.9%.

Such rates are at historically low levels. The risk seems to be at its greatest as interest rates can seemingly only rise. The question is how soon; as history shows, that might be years away.

The Duration metric tells us how sensitive a fixed income investment is to a change in interest rate e.g. a duration of 5 means a bond price will fall by about 5% if interest rates rise 1%. Our example Federal Government 2037 bond has a duration of 15.79 according to the GlobeInvestor listing. A 2% rise in required return / yield would see its value drop almost a third. Thus, we can see that long term bonds are very exposed to severe capital losses from rising interest rates.

2) Equities / Stocks
- It is not quite as easy to figure out what return investors currently require since the calculations incorporate assumptions about the evolution of company earnings, dividends and the economy. The proper more complicated method involves taking the current dividend yield and adding an estimate of the future dividend growth rate (see explanation on Tipster). A simpler first approximation is to turn the Price/Earnings (P/E) ratio upside down, i.e. E/P equals company profits over the stock price. As of close of market July 29th, the TSX Composite Index P/E stood at 18.46 according to TMX Money; thus E/P is 5.4%.

The historical range of market P/E ratios gives us a realistic idea of possible changes in required return and the corresponding implication for stock prices. According to the chart in Wikipedia entry on the P/E Ratio, the US S&P 500 Index has fallen to a P/E as low as 4.78 in 1920, or an E/P of 21%. If the all-time low were to happen again, it would mean prices falling a stupendous 78% from the current 21.64 S&P 500 P/E. The average P/E since 1880 is about 16.4. Markets have been going down lately but clearly they could credibly go much lower.

While a rise in required return causes stock prices to drop, companies that have pricing power and are able to raise earnings, thereby restoring the arithmetic that allows a higher price - as E(arnings) rises, so can P(rice) in our E/P formula. Thus the risk impact of rising required return may not be the same for all companies as some, utilities for example, may be more affected in the short term and take longer to recover due to regulatory controls on profits. Industry sectors may also go out of favour, with higher required returns being required to entice investment, which of course means their stock prices will fall. Or the opposite may happen, sectors become favourites - required return falls and stock prices rise.

It must be said again that the above maximum downward numbers look scary. But they are no means inevitable or imminent and the countermeasures outlined in the first blog post in this risk series should go a long way to reduce the negative effects.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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