So bond rates are not ‘lower for longer’

For most of 2016, we have warned investors about the dangers of accepting historically low bond rates as the ‘new normal’. The reality is that US 10-year rates lower than at any time since George Washington was sworn in as the first President of the United States is anything but normal.

Indeed, it is abnormal. In June this year, US 10-year rates plumbed 1.36%, lower than they were during the Great Depression, when unemployment hit 25%. Such low rates were not justified on economic grounds and therefore were evidence of central bank manipulation. In fact, we have a name for central bank manipulation of long bond rates, it’s called quantitative easing.

Manipulation actually hurts consumption

As economist Herb Stein once wryly observed, if something cannot go on forever, it must stop. And there’s another reason why long bond rates cannot not stay low forever. They are having the perversely opposite impact of what was desired. Denmark’s interest rates have been negative for a relatively longer period, stimulating saving and acting as a disincentive for consumption; yes, savings as a percentage of GDP are up and consumption is down, which is precisely the opposite of what central banks had hoped to achieve.

Low bond rates and the corresponding flat yield curves create disincentives for investment, so why take long-term risk when the returns over the short term are the same? Bond rates are the rate against which all investments are compared through the cost of capital calculation. Therefore, low bond rates transmitted higher valuations across all asset classes, ensuring buyers paid higher prices and received correspondingly lower returns.

Companies were then forced to hand back their capital through dividends and buybacks rather than invest productively. This can be seen in the rising dividend payout ratios in Europe, the US and Australia since 2010. In Australia, the payout ratio for the S&P/ASX200 rose from 57% in 2010 to over 80% today. For the Stoxx 600 index in Europe, the payout ratio rose from 43% to nearly 60% and in the US, the S&P500’s payout ratio increased from nearly 26% in 2011 to almost 40% now.

Of course, the corollary to higher payout ratios is lower retained earnings for future growth. At precisely the moment when share prices were at their highest, growth expectations were at their lowest.

Record prices for everything

The only thing low bond rates have achieved is record asset prices. Indeed, since 2012, P/E ratios for Australian stocks increased, and according to the RBA, the highest P/E ratios were attributed to those companies in the ASX200 paying more than 75% of their earnings as a dividend. Real estate, art, wine and collectible low digit licence plates have been smashing records.

A quick look through the sharemarket reveals that infrastructure stocks like Transurban and Sydney International Airport became two of the most expensive companies listed on an EV/EBITDA basis. One has to ask why Sydney International Airport, which geographically can be described as being located on a vacant block at the end of a global cul-de-sac, deserves to be the most expensive listed airport in the world?

So commentators and prognosticators who projected low bond rates forever as part of a ‘new normal’ were in fact unwittingly admitting ‘this time it’s different’.

History, however, shows that this time is never different. Bond rates will rise, in fact they already have. The 10-year Australian bond has risen from a low of about 1.8% in August 2016 to 2.7% while the US counterpart has risen from 1.36% mid-year to over 2.2%.

Bond rates will continue to rise over time because it does the world no good to keep them low. This will not be good for asset prices. Highly geared property investors will feel the full brunt of rising bond rates and those property developers under 40 will wither from the BRW Rich List as quickly as they were germinated.

As higher rates reduce the present values of future cash flows, so investors will devalue assets as well as the multiples they are willing to pay. When bond rates rise, the ‘P’ in the P/E ratio falls. And with payout ratios so high, the ‘E’ in the P/E ratio isn’t providing the growth needed to compensate. Expect to one day look back on this period of low rates, and highly indebted investors paying record high asset prices, with astonishment.

Huge plus for global economic health, eventually

While higher bond rates will be painful for investors over the next three to eight years, it is actually an enormous positive for global economic health and investor returns. Higher bond rates mean higher returns. Before that can happen, however, there will be a much-needed adjustment.

Then come the positives. New investments will be required to meet a real return hurdle to attract funding and the total pool of capital available for investment and future growth will cease diminishing (through higher payout ratios, for example), and begin to grow. Speculative bubbles will burst, transferring wealth from speculators with no patience to long-term investors with patient capital.

Those countries, corporates and consumers with the highest debt will be hit hardest, as they always are. But the much-needed adjustments will be a net positive and very aggressive buying will be the order of the day by the early-to-mid 2020s.

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