Understand How Rising Interest Rates Impact Your Investments

By Amit Rupani

“Interest rates act on asset values like gravity acts on physical matter." – Warren Buffett

Many new homeowners benefited immensely in last 3-4 years because of historic low interest rates. And many old homeowners also benefited by refinancing their higher interest mortgage loan at much lower rates. But now as the interest rate cycle has reversed lately and caught some momentum, its good time to understand how rising rate environment may impact your investments.

There are many variables which are factored to determine the intrinsic value of any asset. Among all variables, Interest Rate is the most important variable in determining the value. That asset can be stocks, bonds, or real estate. Interest rates have inverse relationship with most income generating assets. If interest rates go up, then asset prices go down keeping everything else constant.

If interest rates go down, then asset prices will go up keeping everything else constant.

Bonds:

In bond investments there are two components of losses that an investor faces when interest rates move up: interest component and capital component. I will discuss interest component first.

Assume investor A has an option to invest $1000 in a 10-Year US Treasury bond at 3 percent that pays fixed annual interest. You lend $1000 as principal on Day 1 to US Treasury and on Day 365 investor gets $30 as interest. Investor will get $30 interest at end of every year. At the end of 10 years, US Treasury will pay $1000 principal back to investor along with last and final interest payment of $30. Now our investor A is approached by a childhood friend asking for $1000 loan for 10 years.

Investor wants to help out the friend and is confident in friend's credibility for paying back the loan with interest. Investor provides $1000 loan for 10 years at 3 percent with annual interest payment. Investor A charges the same rate as on-going 10 Year US Treasury Bond rate.

The very next day US Federal Bank decides to increase the interest rates by 0.5%. The new ongoing 10-Year US Treasury Bonds are quoting at 3.5% interest rate, which means investor would get $35 as annual interest payments instead of $30. If our investor A was to lend $1000 to childhood friend the next day, quoted interest rate would have been 3.5 percent. But the deal happened a day before when reference rate was 3 percent. Our unlucky investor A is stuck with lower interest payment at rate of 3 percent.

This is how bond investors face interest component loss when the interest rates move up.

Now let's move to understand loss on capital component. The value of a bond is equal to the present value of the future cash flows that are going to occur. Per our above example, we know what the future cash flows of the loan are going to be; $30 interest payment end of every year and $1000 principal repayment at end of 10th year. So total future cash flow of $1300 in next 10 years.

When you discount these individual yearly cash flows at 3 percent (old interest rate) the value of the bond is $1000 (the amount of the loan principal). But, here's a simple adjustment, when you discount these individual yearly cash flows at 3.5 percent (new interest rate) then the value of the bond drops down to approximately $958.

If the investor is in need of liquidity and wants to sell his bond in the market, investor would not get more than $958, hence capital loss of $42. But if the investor hangs on to that bond for next 10 years and assuming friend (borrower) makes all promised payments on-time, the investor would receive $1300 as total future cash flows and would lose $50 in interest payments.

Stocks:

The intrinsic value of a stock today is equal to the present value of all the future earnings that the business is going to generate. Let's assume that you have a crystal ball and you see that Amazon is going out of business in the year 2068. You also see what Amazon is going to earn every year between 2018 and 2068. Discounting all its future earnings at current interest rates to present value gives you the intrinsic value of Amazon. The very next day US Federal Bank decides to increase the interest rates.

Your crystal ball still shows same future earnings of Amazon that it showed the previous day. But now you will discount those same future earnings at higher interest rate bringing Amazon value lower than the previously computed value that were based on lower interest rates.

Unfortunately, in the real world no one has the crystal ball and a lot of assumptions/judgment goes into ascertaining the future earnings of any business. Any quick adjustment of price is mainly driven by change/increase in interest rates.

By now we know that present value drops as interest rates move up keeping everything else constant. This concept applies to any asset that generates income; crop producing farmland, rental income generating real-estate property, or a farmer's milk giving cow.

Happy investing!

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Amit Rupani, CFA is an Independent Investor, practices Value Investing principles, manages money for long-term wealth creation through Equities asset class. Email: rupaniamit@yahoo.com