Good morning and happy Monday!
“Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.”
– Warren Buffett
Today I would like to dive into interest rates and the critical role they play in investing, both stocks and bonds.
As a general rule stocks love low interest rates … the lower the better. Why? Because this reduces borrowing costs for companies allowing more money to go to profit or reinvestment into the business enterprise.
As is the case for many of my economic lessons, please allow me to use an example to illustrate.
Let’s say a company has $1,000,000 in profit before interest expenses for a year and has borrowed $500,000 @ an 8% interest rate. The interest expense for this company is $40,000 in that year. That takes down their profits by 4%. If interest rates go down and they can refinance their debt from 8% to 6% then their interest costs will decrease from $40,000/year to $30,000/year … a $10,000/year savings which increases the profits of the company by 1%. That one interest rate changes results in a $10,000 raise for the owners of this company in this example.
Rising interest rates make interest borrowing costs go up, which makes profit margins squeezed, which makes companies less valuable, which lowers stock prices (as a general rule).
Companies that have higher levels of leverage (great level of debt) are more subject to interest rates because their profits are more tied to how much they are paying on interest in their debts.
Growth companies and smaller companies tend to have higher levels of debt than larger companies and value companies, which is another factor involved in the investing landscape.
On to bonds.
Bonds benefit from lower interest rates in the short-term, but it’s a different story for the long-term. I’ll attempt to explain.
Let’s say you purchased a 10-year bond for $100,000 at an interest rate of 6%. What happens to you if you keep your bond for the full 10 years? You will get 6% per year in interest ($6,000/year in this example). Pretty simple, right?
But let’s say 2 years later the going interest rate for an 8-year bond is 4% and you are still making 6% on your 10-year bond for 8 more years. If you decide to sell that bond you would be able to charge a premium. You are getting 6% and the market is only paying 4%, so slightly over-simplified math would say you could charge 2% more per year. Since you have 8 years remaining on the bond term you could charge 16% more (2% per year x 8 remaining years). That means in this example you made $6,000 in year one and $6,000 in year two of owning the bonds and then you turned around and sold your bond for $116,000 … resulting in $128,000 return on an 8-year bond holding. Pretty amazing (again, just a hypothetical), and this illustrates why bonds love lower interest rates in the short term.
Now, over the longer term, lower bond rates are not good for bond holders because they make less of a return on those bond holdings. Would you rather make 4% or 6% as a bond holder? Of course, you would rather make 6% but if the lower interest rate environment means you have to settle for 4% then over time you are less happy.
It’s important to point out here that the opposite happens in a rising interest rate environment. If I purchased that 10-year bond for 6% and 2 years later the market is offering an 8-year bond at 8% now I would have to sell my bond at a discount. Basically, the example above is reverse. 2% discount per year x 8 years = 16% discount, so my $100,000 bond would only sell for roughly $84,000. I still would have made $6,000 in year 1 and $6,000 in year 2, but selling a $100,000 bond for $84,000 means I lost a total of $4,000 over that 2 years period of time ($100,000 + $6,000 year 1 interest + $6,000 year 2 interest – $16,000 discount = $96,000, a $4,000 net loss).
Are we having fun yet? 😉
Bottom line: interest rates matter a lot! It is one of the many factors that we monitor constantly in our portfolio construction.
I hope today’s memo was not too boring, but as always, feel free to reach out if you would like me to dive in further on a topic. I know you’ll be surprised to learn that I have a lot more to say 😉
Thanks for being the most amazing client base in the world! It’s an honor to work with you and serve you.
Make it a great week ahead.