Why Do Asset Prices Fall When Interest Rates Increase?

Understanding the Relationship Between Asset Prices and Interest Rates

Interest Rates and Asset Prices
All else equal, when interest rates increase, asset prices must decline. Why does this happen? It comes down to two primary forces. E+ / Getty Images

One of the dangers of record-low interest rates is they inflate asset prices; things such as stocks, bonds, and real estate trade at higher valuations than they would otherwise support.  For stocks, this can lead to higher-than-normal price-to-earnings ratiosPEG ratiosdividend-adjusted PEG ratios, price-to-book value ratios, price-to-cash flow ratios, price-to-sales ratios, as well as lower-than-normal earnings yields and dividend yields.

 All of this can seem fantastic if you're fortunate enough to be sitting on significant holdings prior the decline in interest rates, allowing you to experience the boom all the way to the top, seeing your net worth grow higher and higher with each passing year despite the fact the rate of net worth increase is outpacing the rate of increase in passive income, which is what really counts.  It's not so great for the long-term investor and/or those without many assets put aside who want to begin saving, which frequently includes young adults just out of high school or college, entering the workforce for the first time.

That might sound odd if you are not familiar with finance or business valuation but it makes a lot of sense if you stop and think about it.  When you buy an investment, what you are really buying is future cash flows; profit or sales proceeds that, adjusted for time, risk, inflation, and taxes, you believe are going to provide an adequate rate of return, expressed as a compound annual growth rate, to compensate you for not consuming your purchasing power in the present; spending it on things that provide utility such as cars, houses, vacations, gifts, a new wardrobe, landscaping, dinners at nice restaurants, or whatever else brings a sense of happiness or joy to your life, augmenting that which really matters: Family, friends, freedom over your time, and good health.

 When asset prices are high due to low interest rates, it means each dollar you spend buying an investment purchases fewer dollars of dividends, interest, rents, or other income (both direct or look-through, in the case of companies that retain earnings for growth rather than pay them out to shareholders).

 Indeed, the rational long-term investor would do cartwheels at the prospect of a stock market offering dividend yields in excess of 2x or 3x the normalized Treasury bond yield or a real estate market that could provide 5x or 10x the normalized Treasury bond yield.  For what they lost in carrying value on the balance sheet, making them look poorer on paper, they'd gain in additional monthly income, allowing them to acquire more; a case of economic reality beating accounting appearance.

Still, even if you know all of this, you may wonder why asset prices fall when interest rates rise.  What is behind the decline?  It's a fantastic question.  Although far more complicated were we to delve into the mechanics, at the heart of the matter, it mostly comes down to two things.

1. Asset Prices Fall When Interest Rates Rise Because the Opportunity Cost of the "Risk-Free" Rate Becomes More Attractive

Whether they realize it or not, most people have enough common sense to compare what they can earn on a potential investment in stocks, bonds, or real estate to what they can earn from parking the money in safe assets.  For small investors, this often is the interest rate payable on an FDIC insured savings account, checking account, money market account, or money market mutual fund.

 For larger investors, businesses, and institutions, this is the so-called "risk-free" rate on U.S. Treasury bills, bonds, and notes, which are backed by the full taxing power of the United States Government.

If the "safe" rates increase, you, and most other investors, are going to demand a higher return to part with your money; to take risks owning businesses or apartment buildings.  This is only natural.  Why expose yourself to loses or volatility when you can sit back, collect interest, and know you'll eventually get your full (nominal) principal value back at some point in the future?  There are no annual reports to read, no 10-K's to study, no proxy statements to peruse.

A practical example might help.

Imagine the 10-year Treasury bond offered a 2.4% pre-tax yield.  You are looking at a stock that sells for $100.00 per share and has diluted earnings per share of $4.00.

 Of that $4.00, $2.00 is paid out as a cash dividend.  This results in an earnings yield of 4.00% and a dividend yield of 2.00%.

Now, imagine the Federal Reserve increases interest rates.  The 10-year Treasury ends up yielding 5.0% pre-tax.  All else equal (and it never is, but for the sake of academic clarity, we'll assume as such for the moment), investors might demand the same premium to own the stock.  That is, prior to the rate rise, investors were willing to buy shares in exchange for 1.6% in extra return (the differential between the 4.00% earnings yield and a 2.40% Treasury yield).  When the Treasury yield rose to 5.00%, if the same relationship holds, they would demand an earnings yield of 6.60%, which translates into a dividend yield of 3.30%.  Absent other variables, such as changes in the cost of the capital structure (more on that in a moment), the only way the stock can deliver that level of profit and dividend is to fall from $100.00 per share to $60.60 per share, a decline of nearly 40.00%.

This isn't problematic at all for disciplined investor, given, of course, that the inflation rate remains benign.  If anything, it's a great development because their regular dollar cost averagingreinvested dividends, and new, fresh capital invested from paychecks or other sources of income now buy more earnings, more dividends, more interest, more rents than was previously possible.  They also benefits as companies can generate higher returns from share repurchase programs.

2. Asset Prices Fall When Interest Rates Rise Because the Cost of Capital Changes for Businesses and Real Estate, Cutting Into Earnings

A second reason asset prices fall when interest rates increase is it can profoundly influence the level of net income reported on the income statement.  When a business borrows money, it does through through either bank loans or by issuing corporate bonds.  If the interest rates a company can get in the market are substantially higher than the interest rate it is paying on its existing debt, it will have to give up more cash flow for every dollar of liabilities outstanding when it comes time to refinance.  This will result in much higher interest expense.  The company will become less profitable since bond holders in the newly issued bonds used to refinance old, maturing bonds, or newly issued bonds necessary to fund acquisitions or expand, now demand more of the cash flow.  This causes the "earnings" in the price-to-earnings ratio to decline, meaning the valuation multiple increases unless the stock declines by an appropriate amount.  Put another way, for the stock to stay the same price in real terms, the stock price must decline.

This, in turn, causes the so-called interest coverage ratio to decline, too, making the company appear riskier.  If that increased risk is sufficiently high, it might cause investors to demand an even bigger risk premium, lowering the stock price even more.

Asset intensive businesses that require a lot of property, plant, and equipment are among the most vulnerable to this sort of interest rate risk.  Other firms - think of Microsoft back in the 1990's when it was debt-free and required so little in the way of tangible assets to operate, it could fund anything and everything out of its corporate checking account without asking banks or Wall Street for money - sail right by this problem, totally non-affected.

Several types of businesses actually prosper when and if interest rates rise.  One illustration: Insurance conglomerate Berkshire Hathaway, built over the past 50+ years by now-billionaire Warren Buffett.  Between cash and cash-like bonds, the company is sitting on $60 billion in assets that is earning practically nothing.  If interest rates were to increase a decent percentage, the firm would suddenly be earning billions upon billions of dollars in additional income per year from those reserve liquidity holdings.  In such cases, it can become particularly interesting as the factors from the first item - investors demanding lower stock prices to compensate them for the fact Treasury bills, bonds, and notes are providing richer returns - duke it out with this phenomenon as the earnings themselves grow.  If the business is sitting on enough spare change, it's possible the stock price could actually increase in the end; one of the things that makes investing so intellectually enjoyable.

The same goes for real estate.  Imagine you have $500,000 in equity capital you want to put into a real estate project; perhaps build an office building, construct storage units, or develop an industrial warehouse to lease to manufacturing firms.  Whatever project you create, you know you must put 30% equity into it to maintain your preferred risk profile, with the other 70% coming from bank loans or other sources of financing.  If interest rates increase, your cost of capital rises.  That means you either have to pay less for the property acquisition / development or you have to be content with far lower cash flows; money that would have gone into your pocket but now gets redirected to the lenders.  The result?  Unless there are other variables at play that overwhelm this consideration, the quoted value of the real estate must decline relative to where it had been.  (Strong operators in the real estate market tend to buy properties they can hold for decades, financing on terms as long as possible so they can arbitrage depreciation in the currency.  As inflation chips away at the value of each dollar, they increase rents, knowing their future maturity repayments are smaller and smaller in economic terms.)