One of the dangers of historically low interest rates is they can inflate asset prices. As a result, 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 ratios, PEG ratios, dividend-adjusted PEG ratios, price-to-book-value ratios, price-to-cash-flow ratios, price-to-sales ratios, and lower-than-normal earnings yields and dividend yields.
All of this can seem fantastic if you bought stocks prior to the decline in interest rates, allowing you to experience the boom all the way to the top. It's not so great for those without many assets put aside who want to begin saving, such as young adults just out of high school or college.
The opposite is also true, however. When interest rates rise, asset prices can decline below what they would normally be worth. But why does this happen? What is behind the decline? Although it can get quite complicated, it mostly comes down to two things.
The "Risk-Free" Rate Becomes More Attractive
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 is often 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.
If the "safe" rates increase, you will be less inclined to part with your money or take any risks. This is only natural. Why expose yourself to losses 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-Ks to study, no proxy statements to peruse.
Example: When It Pays to Play It Safe
Imagine the 10-year Treasury bond offered a 2.4% pre-tax yield. You are looking at a stock that sells for $100 per share and has diluted earnings per share of $4. Of that $4, $2 is paid out as a cash dividend. This results in an earnings yield of 4.4% and a dividend yield of 2%.
Now, imagine the Federal Reserve increases interest rates. The 10-year Treasury ends up yielding 5% pre-tax. All else equal, why would you buy a stock that has a lower return? The only motivation to buy stocks instead of Treasuries under this scenario would be if the price of the stock dropped in value.
The Costs of Capital Rise
A second reason that asset prices will fall when interest rates rise is because the cost of capital increases. This impacts businesses and real estate by cutting into earnings—it can profoundly influence the level of net income reported on the income statement.
When a business borrows money, it does so either through 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 expenses. This causes earnings to decline, which in turn causes the stock price to decline.
This also causes the so-called interest coverage ratio to decline, too, making the company appear riskier because it has less cash available to cover its interest payments. 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 sail right by this problem, totally unaffected.
Some Positive Effects of Rising Interest Rates
Several types of businesses actually prosper when interest rates rise. Often, these are firms that have a lot of cash and liquid holdings. If interest rates were to increase a decent percentage, the firm would suddenly be earning billions of dollars in additional income per year from that money.
This can get particularly interesting as investors—who are demanding lower stock prices to compensate them for the fact Treasury bills, bonds, and notes are providing richer returns—battle with the fact that earnings themselves are growing. If the business is sitting on enough spare change, it's possible the stock price could actually increase in the end.
The same goes for real estate investors. Imagine you have $500,000 in equity capital you want to put into a real estate project. 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, or you have to be content with lower cash flows—money that would have gone into your pocket but now gets redirected to the lenders. The result? The quoted value of the real estate must decline relative to where it had been.