Investing in a Low-Yield Environment

The graph to the right traces the yield of the 10 Year U.S. Treasury Note since 1962. The causes for the long-term downward trend since 1981 are well-known: the Volcker Fed breaking inflation and, for the last 12 years, persistent Quantitative Easing. It is not hyperbole to say that interest rates today are historically low.

Historically low interest rates have several implications for investors, some good, some not so good, and some confounding. This blog describes some of those implications and what we at Peloton believe are investors’ best responses to this environment.

Excess Liquidity

For most of the Federal Reserve’s history, the central bank has carried out our nation’s monetary policy by gradually decreasing and increasing the Federal Funds rate, or the rate banks charge each other to meet overnight capital requirements. Following the 2008-09 financial crisis, the Fed relieved banks of their troubled mortgage-backed securities, and in 2020 it began to purchase corporate bonds to stabilize capital markets in the wake of the pandemic and economic shutdown. During both of these periods, the Fed also bought U.S. Treasury bonds issued to make stimulus payments to individuals and businesses. This “Quantitative Easing” resulted in enormous liquidity within the financial system. At first economists were leery of such an increase in the money supply, but they later grew more comfortable when inflation did not return in a destructive way.

Excess liquidity today is producing some strange behaviors worth noting. One is retail investors’ resurgent interest in stocks. Rather than using stimulus payments on sporting events and movie tickets, some younger investors are speculating in stocks – the message board-fueled short squeeze in GameStop (GME) is a prominent example. Other investors who are troubled by the decline in the U.S. Dollar Index precipitated by the sudden expansion of the money supply have bid up crypto currencies like Bitcoin.

While neither buying Bitcoin nor retail stock trading are bad developments in and of themselves, we urge investors to exercise extreme caution in financial market segments where excess liquidity has a distorting effect on asset values.

Low Discount Rates

One way to measure a stock’s intrinsic value is by discounting expected future cash flows to a present value. If a stock’s annual cost of capital – or the rate it must earn to compensate investors for risk – declines because interest rates are generally lower, the present value of future cash flows will be higher. Part of the reason stock prices have been broadly stronger since last spring is that the Fed’s QE programs have driven the effective discount rate lower and the theoretical present value of future cash flows higher.

Low discount rates are not the whole story, though. Another, more impactful reason for higher stock prices is that many companies are growing revenues and operating profits at attractive rates. Periods of sudden economic change typically allow strong companies to survive and grow, while weak companies fail. Stock prices supported by low discount rates has the effect of raising intrinsic values for both strong and weak companies. As interest rates rise in years to come, higher discount rates will strain weak companies. Here, too, we urge caution when investing in stocks as prices rise – all stocks are not equal, and momentum reverses quickly.

Depressed Bond Yields

While low interest rates are good for borrowers, traditional bond investors receive less income. However, interest income remains an important part of a balanced portfolio, but it’s not the only reason for owning bonds. Because bonds are senior to stocks within the corporate structure, interest payments and the return of principal (at maturity) are more reliable than returns on stocks. We structure balanced portfolios to ensure that portfolio cash flows – including stock dividends, bond interest, and principal repayments – meet distribution requirements, without relying on stock prices.

Conclusion

A low yield environment creates a number of potential pitfalls for investors. However, low interest rates are not necessarily a problem, rather a circumstance to navigate carefully. If you have questions about how to invest successfully in this environment, we welcome the opportunity to discuss it with you.

 

Disclosures

Pelton does not own Bitcoin or shares of GameStop Corp (GME) in its managed portfolios. For a list of holdings please refer our Form 13F-HR. Past performance is no guarantee of future results.  Investing involves risk, including possible loss of principal.  Diversification may not protect against market risk or loss of principal.  The opinions expressed above should be construed as neither investment advice nor a solicitation to buy or sell securities.  Actual investor results may vary.

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