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The curious case of falling interest rates


The curious case of falling interest rates

What a month it has been in global fixed income markets! Global risk-free interest rates have been on a steady decline. In the US, the Treasury yield curve has shifted down to the tune of 30-50 basis points. In Australia, it has shifted down to the tune of 30-40 basis points.

(A sovereign yield curve shows the annual interest rate you can obtain for lending to the government, on the vertical axis; versus the tenor of that loan measured in years, on the horizontal axis).

US Treasury Yield Curve (Green) vs 1Month Prior (Yellow)


Australian Sovereign Yield Curve (Green) vs 1Month Prior (Yellow)


In Germany, any loan you make to the government with tenor 10 years or less carries with it a negative interest rate today. That’s right – you need to pay the German government for the privilege of lending it money! It sounds strange, and it is.

There are many possible reasons for this sudden decline in global risk-free interest rates – and we will delve into these another day. For today, I offer you an interesting thought experiment.

When analysts determine the value of a stock, they essentially forecast the future cash flows generated by the underlying business that will be returned to shareholders. Analysts will then aggregate these cash flows – but do so in a way that discounts future cash flows. The idea is that $100 today is worth more to you than $100 in one year from now because you could have invested that $100 and earned a return in the meantime.

The rate at which future cash flows to shareholders are discounted is typically around 10 per cent. And there is a lot of finance theory as to why this is. In short, the discount rate is supposed to reflect the premium over the risk-free rate that equity investors require for bearing equity risk.

The point is, the discount rate is referenced to the risk-free rate. So if global risk-free rates are falling, then finance theory would suggest that equity cash flows should also be discounted at a lower discount rate (all else equal). And as the discount rate falls, valuations increase.

So, if we are moving into a world in which global interest rates are lower for longer, what does this mean for fair equity valuations?

What do you think?


Andrew Macken is the Chief Investment Officer of the Montaka funds and the Montgomery Global funds. He established MGIM in 2015 in partnership with Montgomery.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. low interest rates scare me. Its not natural, its not sustainable. People are simply taking more and more risk to offset low bond market yields, and when it ends, it will be very ugly. I simply cannot understand why the sharemarket continues to rise. I am beginning to doubt my own sanity. God, i would hate to be a fund manager.

  2. Robert Pearson

    As Steven points out the addition of a risk interest rate to the actual, is a convention. To further confuse matters the DCF (or similar) calculation assumes that the future interest rates as well as the profits of the company can be estimated. Also that the series converges quickly enough so that the company still exists. Further as Dr Price in his book ‘The Conscious Investor ‘ points out the calculation is not robust in that small changes in the values of the parameters can yield large changes in the results.

      • Yep, in this environment a UBI might become a standard feature, I think as Steve Keen has suggested part of the ‘freedom dividend’ (maybe %30) will have to be directed at paying of one’s debts.

        In this context persons might be less keen to take on debt because they will know that it will eat into their UBI payment?/

  3. andrew ronan

    Negative rates are just a sign that the Keynesian system is finished, I’d say the next decade will bring about untold upheaval, it’s started already in places like France with the yellow vest movement, not many people even know the extent of these things because the mainstream media hide it, polititions lie to the people to calm them, as is happening right now in Australia, but this crazy BS way of running society is nowhere near sustainable in the long term,
    age demographic trends and negative birth rates and deflation due to tech displacing labour etc
    are not things that can be fixed by devaluation of currency, society will have to face these reality’s head on eventually, inflation of asset prices only benefits those with assets, alienating those without, ie the young,
    Observation of current trends within the young population suggest socialism is coming, maybe full communism.
    I’ve been buying PMs and that’s looking like a good move atm, gold hitting record highs in aud, silver coiling. Can’t be printed or bailed in either, the more they print the higher commodity’s go, including PMs .

  4. Negative interest rate on bonds will lead to private investors abandoning investing in bonds, leaving only central banks as the sole purchasers of public debt, aka monetisation of debt.
    But eventually inflation will pick up and the debt market will collapse, with or without interest rate rises. With negative interest rate, the carrying cost of precious metals become negative and that would encourage people to buy gold and silver.

  5. [i don’t see an attachement button];
    Buffett and Munger use several methods which are at odds with traditional financial theory. Here is one of those nontraditional approaches:

    Buffett: “We don’t discount the future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”

    There is no law of nature requiring that a capital allocation process account for risk, uncertainty and ignorance by adjusting the interest rate. Buffett and Munger instead use the concept of margin of safety. Having a margin of safety and also adjusting the interest rate would be redundant in their view. They:

    1. Assemble options to invest that involve businesses which have a future that is “quite certain” and is within their circle of competence
    2. Use the 30 year rate to do the DCF in their head on all these opportunities
    3. Apply a margin of safety
    4. Compare every option available to then anywhere on Earth and chose the best one.

    This makes some people nuts since they were trained to adjust the interest rate to account for risk. I’m not taking a personal position here and am instead trying to better explain the Buffett/Munger approach.

    The two methods are different ways of accomplishing the same thing, so why do Buffett and Munger use their own approach? I believe they prefer their method since it frames the ultimate question in a way that they prefer. They hate the idea of someone saying “invest in X since the return is above your hurdle rate” since that decisions can be made only by looking at every other alternative in the world. By using the same 30 year US Treasury rate for every DCF he has created a “system to compare things.” The things Buffett compares side-by-side must be “quite certain” and available to buy at a significant discount to intrinsic value reflecting a margin of safety.

    My friend John Alberg a co-founder of http://www.euclidean.com/ puts it this way:

    “Another way of saying it is that all investments share the same discount rate. You can’t apply a different discount rate to company A than company B because $1 in the future is worth the same amount of money regardless of whether it comes from company A or B. So instead an investor should focus on the cash that a business can generate within a margin of safety and compare them by that measure. With respect to DCF, the reason that it can be “done in the head” is because it simplifies to a simple ratio when you use margin of safety. That is, if most future cashflows from company A are going to be greater than some number c_A and the discount rates are going to be greater than some other value r then the quantity c_A / r is less than the result you would get from a DCF. Put another way, the quantity c_A / r is a lower bound on the DCF or it is an estimate of intrinsic value with a margin of safety. But notice that if you are comparing the intrinsic value of two companies with cashflows of at least c_A and c_B then the discount rate r is constant between the two and therefore not the important part of the equation.”

    Buffett and Munger have a flow of deals that cross their desks. We don’t see them but Byron Trott recently said that many investors would cry over losing what they turn down. That flow established their opportunity cost. 30-year US treasury rates can be 3%, but if they have a flow of deals that return 10% that is “sort of” their hurdle rate.

    Munger: “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs.”

    Munger: “There is this company in an emerging market that was presented to Warren. His response was, ‘I don’t feel more comfortable buying that than I do of adding to Wells Fargo.’ He was using that as his opportunity cost. No one can tell me why I shouldn’t buy more Wells Fargo. Warren is scanning the world trying to get his opportunity cost as high as he can so that his individual decisions are better.”

    Under the Buffett/Munger approach the risk free rate used in the discounted cash flow (DCF) and the “next best opportunity” are not connected. Sometimes you will hear people incorrectly say Buffett is hinting at adjusting the discount rate or inconsistent in his approach. If you read him carefully his “sort of” hurdle rate is the next best investment (which can have a number attached to it) based on the deals crossing his desk. In looking at next best he’s looking broadly thinking about what may cross his desk in a few years. Right now his next best opportunity is probably at a bit less than the customary 10%. What he is adjusting is not the discount rate but the next best opportunity rate.

    Buffett: “The trouble isn’t that we don’t have one [a hurdle rate] – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly. Everything is a function of opportunity cost.”

    Buffett: “We use the same discount rate across all securities. We may be more conservative in estimating cash in some situations. Just because interest rates are at 1.5% doesn’t mean we like an investment that yields 2-3%. We have minimum thresholds in our mind that are a whole lot higher than government rates. When we’re looking at a business, we’re looking at holding it forever, so we don’t assume rates will always be this low.”

    Buffett: “In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value – in our case, at the long-term Treasury rate. And that discount rate doesn’t pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses.”

    Buffett: “We don’t formally have a discount rate. We want a significantly higher return than from a government bond–that’s the yardstick, but not if government bond rates are 2-3%. It’s a little of wanting enough that we’re comfortable. It sounds fuzzy because it is. Charlie and I have never talked in terms of hurdle rates.

    Buffett: “We just try to buy things that we’ll earn more from than a government bond – the question is, how much higher? If government bonds are at 2%, we’re not going to buy a business that will return 4%. I don’t call Charlie every day and ask him, “What’s our hurdle rate?” We’ve never used the term.

    Munger: “The concept of hurdle rates makes nothing but sense, but it doesn’t work. Hurdle rates don’t work as well as a system of comparing things. Finance departments ignore it, because it’s not easy to teach. Just because you can measure something doesn’t mean it’s the determining variable in an uncertain world. The concept of opportunity cost is overlooked. In the real world, your opportunity costs are what you want to base your decisions on.”

    Buffett: “If [corporate] boards would’ve burned all their charts of IRR [internal rate of return], they would’ve been better off. [They create] nonsense numbers to give their audience what they want to hear and get CEOs what they want.”

    Munger: “I have a young friend who sells private partnerships promising 20% returns. When I asked how he arrived at that number, he said, “I chose that number so they’d give me the money.”

    Buffett: “There’s nobody in the world who can earn 20% with big money. I’m amazed at the gullibility of big investors.”

    Munger: “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs.”

    Buffett: 10% is the figure we quit on — we don’t want to buy equities when the real return we expect is less than 10%, whether interest rates are 6% or 1%. It’s arbitrary. 10% is not that great after tax.”

    Munger: “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs.”
    We could take the $16 billion we have in cash earning 1.5% and invest it in 20-year bonds earning 5% and increase our current earnings a lot, but we’re betting that we can find a good place to invest this cash and don’t want to take the risk of principal loss of long-term bonds [if interest rates rise, the value of 20-year bonds will decline].”

    Buffett: “We don’t formally have discount rates. Every time we start talking about this, Charlie reminds me that I’ve never prepared a spreadsheet, but I do in my mind. We just try to buy things that we’ll earn more from than a government bond – the question is, how much higher?”

    Munger: “Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.”


    Munger: You say there is some vaguely established view in economics as to what is an optimal dividend policy or an optimal investment?
    Professor William Bratton of the Rutgers-Newark School of Law: I think we all know what an optimal investment is.
    Munger: No, I do not. At least not as these people use the term.
    Bratton: I don’t know it when I see it but in theory, if I knew it when I saw it this conference would be about me and not about Warren Buffett.
    Munger: What is the break point where a business becomes sub-optimal or when an investment becomes sub-optimal?
    Bratton: When the return on the investment is lower than the cost of capital.
    Munger: And what is the cost of capital?
    Bratton: Well, that’s a nice one and I would…
    Munger: Well, it’s only fair, if you’re going to use the cost of capital, to say what it is.
    Bratton: I would be interested in knowing, we’re talking theoretically.
    Munger: No, I want to know what the cost of capital is in the model.
    Bratton: In the model? It will just be stated.
    Munger: Where? Out of the forehead of Job or something?
    Bratton: That is correct.
    Munger: Well, some of us don’t find this too satisfactory.
    Bratton: I said, you’d be a fool to use it as a template for real world investment decision making. We’re only trying to use a particular perspective on human behavior to try to explain things.
    Munger: But if you explain things in terms of unexplainable sub-concepts, what kind of an explanation is that?
    Bratton: It’s a social science explanation. You take for what it’s worth.
    Munger: Do you consider it understandable for some people to regard this as gibberish?
    Bratton: Perfectly understandable, although I do my best to teach it.
    Munger: Why? Why do you do this?
    Bratton: It’s in my job description.
    Munger: Because other people are teaching it, is what you’re telling me.

  6. I have been starting to seriously consider the prospect that this is a step change in sovereign rates that could last my investing lifetime. The combination of changing demographics in the developed world, and the enormous wealth flowing through tech/sovereign VC funds means there is simply too much money chasing too little (real) consumer growth… I would prefer to be wrong and my other thought is that this thinking becoming widespread is just classic sign of a “top” and we will look back and laugh at the ridiculous valuations for even boring strong low-growth businesses (Mccormick / Diageo et al @ PE>32???!!).

  7. dane campbell

    Question. In a scenario where all developed economy’s rates go negative (Australia too) where would you(mum. dad, CIOs, super trustees etc) keep your cash? Presumably non-interest bearing bank accounts would cease to exist?? Or would bank interest rates have a floor of zero? If so where does the idle cash flow to? Does this spark liquidity and inflation or does liquidity dry up?
    The subject of negative rates really boggles the mind and to me one of the biggest concerns is liquidity…..thanks for the thought provoking article!

    • Hi Dane, yes I agree negative rates do boggle the mind.
      Some have suggested that if rates were to go too negative, people would start stockpiling physical cash in guarded vaults!
      More practically, the consequence of negative rates tends to be a shifting out on the risk-spectrum for investors. What this means is that investors who would have preferred, say, government bonds now start buying investment-grade corporate bonds; and investment-grade investors start buying high-yield bonds; and high-yield bond investors start buying equities (or property); and so on… As you can imagine, this pushes up all asset prices.
      Thanks for the question.

  8. Hi Andrew

    I tend to think a Fair Equity Valuation in the current environment depends entirely on the Riskiness of the Business you are looking at investing in. Some Businesses are low risk, so a lower return is justified ( say 5- 6%) whereas a high risk (beta) Business demands a much higher return . How much higher depends on lots of variables – You may decide a return of 25% is required or it could be 15% or lower . It’s too difficult to put a single number on it until you appraise that Business.

    Falling Interest rates has resulted in PE expansion even though the Businesses themselves may have become riskier due to challenging trading environments etc. You could be taking on more risk for a lower return and not realize it if your focus on Returns revolves around low interest rates.
    The CAPM should be used with caution as it may not give you the right answer as far as a Fair Equity Valuation is concerned. Remember low interest rates means things are VERY BAD, so it follows that risk has increased and a higher return is required and yet everyone seems to think a lower return is OK because rates are lower – we are a strange lot.

  9. As you say Andy, the discount rate for valuing equities is made up from the addition of the risk free rate and the equity risk premium. As we are being pushed into accepting greater risk through the great QE experiment that is depressing interest rates, then this should continue providing demand for equities and supporting equity prices.
    The fly in the ointment though may be the equity risk premium part of the equation. As prices keep rising due to low interest rates, all sorts of economic and equity pricing risks must be also rising. It is impossible to forecast when one or more of these risks deflate the market, but until then I would suspect that the markets will keep on keeping on under the old axiom of “do not fight the Fed”.

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