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 historically low interest rates is they can 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 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, entering the workforce for the first time.

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, and good compound annual growth rate.

But why do 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. The Opportunity Cost of 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 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.

If the "safe" rates increase, you, and most other investors, are going to be less likely to want tp part with your money or take any risks. 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, 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.

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 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. 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. 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.

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 upon billions of dollars in additional income per year from that money. In such cases, it can become particularly interesting as the fact 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. This is 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. 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 far 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.