Understanding stock movements is relatively straight forward. Rising earnings, dividends and stock prices is generally considered a good thing for equity investors. When considering bonds, the first thought would be that rising interest rates would be positive for bond investors as they would be paid higher interest rates. The reality is a little different in that rising interest rates results in declining bond prices. Bond prices and interest rates have an inverse correlation. So why is it that rising interest rates is negative for bond prices and bond holders?
The easiest way of explaining this is by example. If you buy a ten year bond at $100 that has a 2% coupon, you will earn $20 in interest over the life of the bond. Assuming rates never change and ignoring interest com-pounding (for simplicity), the price of the bond will remain at $100 till the $100 principle is repaid in ten years.
Bonds, like stocks, do trade on a secondary market. You can buy ten year bonds when they are issued (which we will call "new" bonds for our example) or you can buy "used" ten year bonds on the secondary market. For our example, a "used" ten year bond will be considered any ten year bond that has less than ten years to maturity. A "new" bond will turn into a "used" bond the day after they are issued.
Buying a "used" bond with a maturity of ten years less a day is virtually identical to a "new" ten year bond. For our example, we will assume that they are equivalent. If we buy a "new" 2% ten year bond, and the following day interest rates for ten year bonds pop to 3%, "new" bonds issued after the change in interest rates would be priced to yield 3%. These "new" bonds would pay $3 of interest per year or $30 over the ten year life of the bond. Since the bond we bought yesterday (with a 2% coupon) only pays $20 interest over its ten year life, it is obviously less attractive than a bond that pays 3%. There needs to be another mechanism to entice buyers to buy our now "used" 2% ten year bond on the secondary market. This mechanism is price. For buyers to get a 3% equivalent yield from a "used" 2% coupon ten year bond, the price of the "used" 2% bond would drop from $100 to $90 at the same time that interest rate rise to 3%. A buyer (but not the initial holder) of the "used" 2% bond would then realize interest of $20 and capital gains of $10 over the ten year life of the bond (assuming the bond is held to maturity). This is the same as a buyer of a "new" 3% bond receiving interest of $30 over 10 years with a return of principle that is equal to what was paid for the bond. Of course, the initial buyer of the 2% bond (when it was considered "new") would realize a capital loss of $10 / bond when interest rates rose from 2% to 3%. This is why bondholders lose when interest rates rise. Their bonds are re-priced to reflect the higher interest rates.
What happens to the "used" 2% bond over the intervening years? Assuming interest rates remain at 3%, the price of the 2% bond will rise approximately 1% per year. This means that the bond holder will receive both 2% of interest plus 1% in capital gains each and every year. The math also means that the further out the maturity for any bonds held, the larger the loss on the price of the bonds when rates rise, all else being equal. We have already seen an example of what happens when rates rise and how it impacts a ten year bond. If the same example is applied to a five year bond, a rise in interest rates from 2% to 3% will result in the price of a "used" five year bond dropping to $95. The reason the bond price only drops $5 (vs. $10 for the "used" ten year bond) is because buyers of the bond need only a 5% discount to offset the five years of receiving a 2% coupon, in-stead of 3% for the more recently issued "new" bonds.
These examples are extreme, as bonds rarely have such big overnight moves (2% to 3%). While rapid and significant decreases in bond prices do happen, they tend to play out over a number of days and weeks rather than overnight as we have illustrated. While rising interest rates are positive for prospective bond purchasers (as they receive higher rates), they are negative for existing bondholders due to bond price declines.
Wednesday, July 17, 2013
ITS ALL ABOUT THE FED (Again)
This quarter’s newsletter will focus exclusively on the US markets. The European and foreign markets have remained relatively stable. The key influence on the US markets are the recent statements by Federal Reserve Board Chairman Bernanke. His remarks, which are typically cryptic, leads to a positive “read” on the US economy.
The financial markets saw a marked increase in volatility during the recently completed fiscal quarter. The quarter began on a strong note with a strong upward trend. Mid-quarter comments from The Federal Reserve Board (the Fed) Chairman Bernanke concerning a sooner than expected end to the Fed’s easy money policies resulted in a sell off in all asset classes. Both stock and bond markets posted significant declines in a relatively short period of time as investors adjusted to the prospect of higher interest rates. The US stock market (as measured by the S&P 500) gained 2.4% during the quarter, while the Canadian Market (as measured by S&P/TSX 300) declined 4.9%. Exposure to resource and gold stocks weighed heavily on the Canadian market. The Canadian bond market declined 2.4% as yields on the benchmark five year bond increased from 1.2% to 1.8%.
Chairman Bernanke’s comments signalled conditions for a change in monetary policy. He reiterated that the Fed would not remove the excess liquidity previously injected into the financial system thus avoiding the risk of creating a tighter credit environment. The Fed has no interest in contracting credit conditions and potentially choking off the fragile economic recovery. The Fed would initially reduce bond purchases prior to commencing a money tightening policy. A 1% rise in interest rates from current historically low interest rates, would be unlikely to hinder economic growth.
Any discussion of an impending transition from an “easy money environment” of low interest rates to a more neutral policy will result in heightened investor anxiety. We believe that the Fed's exiting its ultra low interest rate policy should be viewed as positive. It reflects the anticipation by the Fed of a sustainable, improving US economy. Make no mistake about it, the US recovery is happening. US Auto sales growth remains healthy while housing activity is red hot. The excess supply of housing inventory of two years ago has reversed and there is now an under supply of homes for sale. The result is new home starts reaching post-recession highs and rising home prices. These positive trends have translated into improved employment data.
Over the last couple of years, we have witnessed low interest rates driving stock market gains. This is not sustainable over the long term. A strong, growing economy fuelling growing corporate earnings is needed to support rising stock prices over a longer period of time. The fundamental underpinnings are in place to enable a healthy stock market over the next couple of years. The stock market will not rise in a straight line without corrections. Volatile stock markets have typically been the norm, unlike the relatively calm markets of the last nine months. The stock market is in a choppy consolidation phase, which is likely to persist through the summer. Stock price fluctuations are currently reflecting the tug of war between an improving economy and the prospect of rising interest rates.
We believe that the Fed has the best view of the economy. When investors come around to the concept that rising interest rates is a positive read for economic and corporate outlooks, the stock market will resume its upward trajectory. With the recent bond market decline, we continue to believe that bonds are not a profitable near-term investment. Our concern remains that a stronger economy will result in higher interest rates, even if the majority of the near-term increase has already occurred. From a historical perspective, a move from 1.6% to 2.5% for the US ten year bonds is a big move. While 2.5% is still considered low, it does not provide enough of a cushion to reflect the risk of another big rate increase sometime over the next year.
Our bullish view of the stock market has been based on attractive stock valuations. After the sizable US stock market gains over the last year, it is increasingly difficult to call the market cheap. The US stock market currently trades at 16 times trailing earnings, which is more in line with its historical fair value. As such, we would characterize the stock market as reasonably valued. We prefer not to assume that valuations will rise in excess of fair value when analyzing future market trends. We maintain this conservative approach in order to more realistically determine asset allocations. Future stock price gains are likely to come from earnings growth than from increased valuations. Applying a 16 multiple on 2013 S&P 500 estimates ($108), yields a target of 1730 by the end of this year. This results in a potential 8% return by year end.
Since the recession of 2008-2009, investors have flocked to bonds due to their perceived safety and income orientation. Chart 1 highlights that only in the last year have investors begun to put money back into the stocks. Equity markets inflows have been inconsistent and still represent only a fraction of the money that has poured into bond funds over the last four years. As a significant amount of money remains sitting in cash accounts or bonds, stock market inflows could persist for a number of years. The great rotation from bonds into stocks has barely begun.
Chart 1: Cumulative Fund Flows
We remain positive on the US stock market due to an improving economy, increasing corporate earnings and relatively low interest rates. We believe that the US stock market offers the best potential risk adjusted returns. Valuations rising to something closer to fair value have made individual stock selection increasingly important in generating positive returns.
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