Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 290

Watch for one rule that applies to all assets

Many readers understand the inverse relationship between bond prices and bond interest rates. Bonds usually carry a fixed coupon payment that reflects interest rates at the time of issue, and the promise to pay the principal back at maturity. Once bonds start trading in the secondary market, the price of the bond can change with the yield – remember the coupon payments are fixed - moving in the opposite direction to the price.

Investors overlook that the relationship between interest rates and values applies to all income-producing assets.

Think of a rental investment property with a stable tenant who pays the same rent every week for decades. The income from the property stays the same so the payment of a higher price for the property results in a lower yield and the payment of a lower price for the property results in a higher yield.

I have deliberately introduced property as an example to help explain that it is not only bonds that share an inverse relationship with interest rates. And that’s important to keep in mind when one considers the structural change in the stance of central banks around the world, which we will come to in a moment.

The higher the price, the lower the return

An unforgettable investing rule is the higher the price you pay, the lower your returns. If, for example, a non-dividend-paying company’s shares trade at $40 in November 2029 – say 10 years from now – then paying $10 for them today will deliver a 14.86% compounded annual return. But paying $21 for those shares today, the return drops to 6.6%.

Flipping this, if a business generates $40 of cash flow in January 2029, what is that future $40 worth today? The answer depends on the rate used to ‘discount’ that future cash flow back to today. If we demand a 15% return on our investment over the next 10 years, the value of that future $40 is worth $9.89 today. If we are satisfied with a 6.6% annual return on our money, then that future $40 is worth $21 today.

By lowering the rate of investment return from 15% to 6.6%, we increase the present value of a future cash flow from $9.89 to $21. In other words, when interest rates (required returns) fall, the value of an asset rises. The reverse is also true. In the example above, if interest rates rise from 6.6% to 15%, the value of that future $40 falls from $21 to $9.89.

The rule applies to all assets

As interest rates rise, asset values fall. It applies to all income-producing assets – businesses, shares, property, bonds. And as the value of income-producing assets fall, banks are less inclined to lend, which reduces liquidity and the money available to speculate on non-income-producing assets such as art, wine, cars and low digit number plates.

The chart above follows the rapid growth in central bank balance sheets since 2009 when they collectively commenced the greatest monetary experiment of our time. They paid cash to banks and investors for their bonds and pushed bond prices up and yields down.

The hitherto ‘building up’ of central bank balance sheets has now gone into reverse as the US Fed started reducing its balance sheet by allowing bonds to mature, and through the cessation of purchasing more. Meanwhile, the Bank of Japan (BoJ) and the European Central Bank (ECB) have entered Quantitative Tapering by reducing their purchases initially, followed by presumably ceasing altogether.

What happens when you remove from the bond market the biggest constant buyers of bonds in the last 10 years? Bond prices stop going up and start falling and bond yields stop going down and start rising.

In addition to the biggest buyers being removed, a new seller has emerged in the form of the US Treasury issuing bonds to fund Donald Trump’s fiscal deficits. Remember all those tax cuts? The hole left in the budget from the reduction in tax revenue needs to be plugged with borrowings and that means an increase in the supply of bonds.

Why 2018 was a transition year

Take out the biggest bond buyer and introduce a new large seller and bond prices go down and yields go up. The difference this time around is that it appears to be structural rather than cyclical and the quantum of the change may yet overwhelm other typical influences on bonds.

It makes 2018 a transition year. Although US 10-year bond rates have been rising for more than two years - from a low of 1.36% in 2016 to more than 3.2% late last year - the stock market only seemed to react last year. As is often the case when rates start rising, the markets were initially buoyed by the economic growth that typically accompanies rising rates.

Eventually, the exuberance about inchoate economic growth gives way to concerns about the effect on asset values from rising rates. At that juncture, Price/Earnings ratios are generally extended thanks to the prior exuberance.

Consequently (and especially if rates keep rising), those investors who paid record prices for everything from property to collectibles may now experience poor returns. The only question is whether those lower returns are accompanied by higher volatility as well.

Switch from corporate to government bonds

The higher yields on government bonds are starting to look more attractive. Consequently, investors who were overweight corporate bonds are selling those bonds, pushing their yields higher too. You can see this in the market value of Corporate Bond ETFs such as the iShares IBoxx US Dollar Investment Grade Corporate Bond Fund (NYSEARCA:LQD), which has fallen from over US$116.00 to US$111.00 since August 2018. Yes, bond ETF prices can fall and are not as defensive an asset as many think.

The switch from US corporate bonds to US Treasuries is occurring at a time when a record 47% of all US corporate bonds are rated the lowest BBB investment grade, and 14% of S&P1500 companies are considered ‘zombie’ companies unable to pay their interest from earnings before interest and tax. I would not be surprised, as interest rates on these bonds rise, that the high levels of leverage results in a significant number of downgrades to these BBB bonds by the ratings agencies.

Perhaps even more worrying, a credit market record level of CCC-rated high yield (previously called 'junk') debt is due to be refinanced in 2019 and 2020.

It all suggests more volatility. For investors who remember the rule about higher prices and lower returns, they may already have a stash of cash ready to take advantage of opportunities.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information and does not consider the circumstances of any individual.

RELATED ARTICLES

The RBA’s QE losses

Globalisation is morphing into something less promising

Three reasons high inflation may trigger a European crisis

banner

Most viewed in recent weeks

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Latest Updates

SMSF strategies

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Superannuation

The huge cost of super tax concessions

The current net annual cost of superannuation tax subsidies is around $40 billion, growing to more than $110 billion by 2060. These subsidies have always been bad policy, representing a waste of taxpayers' money.

Planning

How to avoid inheritance fights

Inspired by the papal conclave, this explores how families can avoid post-death drama through honest conversations, better planning, and trial runs - so there are no surprises when it really matters.

Superannuation

Super contribution splitting

Super contribution splitting allows couples to divide before-tax contributions to super between spouses, maximizing savings. It’s not for everyone, but in the right circumstances, it can be a smart strategy worth exploring.

Economy

Trump vs Powell: Who will blink first?

The US economy faces an unprecedented clash in leadership styles, but the President and Fed Chair could both take a lesson from the other. Not least because the fiscal and monetary authorities need to work together.

Gold

Credit cuts, rising risks, and the case for gold

Shares trade at steep valuations despite higher risks of a recession. Amid doubts that a 60/40 portfolio can still provide enough protection through times of market stress, gold's record shines bright.

Investment strategies

Buffett acolyte warns passive investors of mediocre future returns

While Chris Bloomstan doesn't have the track record of his hero, it's impressive nonetheless. And he's recently warned that today has uncanny resemblances to the 1990s tech bubble and US returns are likely to be disappointing.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.