As of the latest observation, the yield on “risk-free” three month T-Bills was just 0.11 percent. Rates are low across the yield curve, with the recent yield on the 10-year Treasury just 0.74 percent. For comparison, even during the extremely low rates of 2012, the yield on the 10-year bottomed around 1.5 percent. During the 1990s, the average yield on the 10-year was 6.66 percent.
These historically low interest rates have a profound effect on capital markets. Perhaps most importantly, they suggest lower potential returns in the future. Let’s look at how low rates affect the price of everything, and then discuss what options investors have in this world of low yields.
Discounting Future Flows Buyers and sellers come to an agreement on the value of a company and its stock based on expectations about future cash flows from its earnings. All else equal, when a company is expected to have faster growth in the future, the present value of the company will rise, and its stock will go up. From a mathematical and theoretical perspective, interest rates can also affect the agreed-upon present value, even without a change in expectations about future growth. Let’s say you’ve been promised five dollars every year for the next 10 years.
What would you be willing to pay today for such a stream of income? If you expected a 6 percent return on your investment, you would pay $36.80 today for that stream of income.1 When the expected return falls from 6 percent to 2 percent, the value of that same income stream rises to $44.91.2 The stream of payments has not changed, only the expected return, and yet the present value of the future cash flows has increased by 22 percent!
This mathematical and theoretical framework explains much of what has happened in markets this year. Even if future expected cash flows have been hampered by the pandemic, the expected return, or discount rate, has decreased. This makes investors more willing to pay a higher price for the same future cash flows.
*See box, page 86, for representative indexes.
Also In this Issue:
Tax Facts to Know if You’re Selling Your Home This Year
Filing an Amended Tax Return
Quarterly Review of Capital Markets
AIS Sample Allocations and Returns
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow Jones Industrials Ranked by Yield
Asset Class Investment Vehicles
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