why rising rates aren’t good for bonds and stocks (i)

present value

Present value is the worth today of a promised payment that will be made in the future.

There are, of course, lots of risks in any contract like this–the borrower might go in to bankruptcy, or simply refuse to pay… Let’s take the case of a Treasury security, where, in theory anyway, none of the typical commercial risks apply. To make this simpler, we’ll assume that the security we hold is a Treasury principal strip. This is a zero-coupon instrument, that is, one it makes no interest payments. It consists of a lump sum payment of the face value of $1000 at maturity, which we’ll say is five years hence.

If we were buying today, what should we pay, given that interest rates–what we’ll use to discount the future $1000 back to today’s value, are, let’s say, 2%? The answer is

1000/ (1.02)(1.02)(1.02)(1.02)(1.02), or $905.73.

Suppose rates rise to 4% immediately after we buy. What is our security worth now? The new present value is 1000/(1.04)(1.04)(1.04)(1.04)(1.04), or $821.93. If rates rise to 6%, the value would be $747.26.

Were rates to fall to 1% instead, the value would jump to slightly more than $951.

Three points:

–this is the simplest and most volatile case. There are no periodic interest payments, which tend to act as stabilizers of the security’s value

–the US government is assumed to be a totally creditworthy borrower, something that hasn’t always been true (think: the Carter administration issue of D-mark and Swiss franc bonds), and

–we’re not taking into account possible effects the business cycle might have on valuation, a factor that’s in theory not relevant for Treasuries but something that could have a significant impact on some corporate bonds (think: junk).


“Duration” is the name for a family of related concepts, the first of which was introduced by Frederick Macaulay. They all use a weighted average of the present values of the cash flows from a bond–interest payments and return of principal–as a way of assessing its sensitivity to changes in interest rates. The basic result is a more muted version of the Treasury strip behavior illustrated above: the farther in the future the preponderance of the cash flows (i.e., the closer it is to a zero-coupon bond), the more the bond moves down as interest rates rise and rises as rates fall.

stocks vs. bonds

The main thrust of the academic financial theory of stocks, as I see it anyway, is to describe them as a peculiar type of bond. This idea has the advantages of simplicity and of piggybacking on the well-developed, present value-based structure of bond analysis and applying it to equities. It also has the disadvantage of not working particularly well, and of functioning increasingly less well as time has passed.

It did work well in the 1950s, when it was developed. The dominant publicly-listed firms back then were ATT, the big integrated oils, miners, steels, automakers, chemicals, stores like Sears and Woolworth… These are the kinds of entities you’d expect to see trading in an emerging market today. Companies had relatively easily forecastable cash flows, dividend yields were high, dividends were perhaps the major investor focus. Also, my sense, which may be incorrect since this is before my time, is that stock market participants back then were mostly very wealthy entities looking for quasi-bonds. Said a different way, lots of value-type stocks were on offer and/because buyers were relatively risk averse and had no stomach for stocks that didn’t look/act like bonds.

Today, we’re in a far different world. Many investors are mainly interested in capital gains, not dividends, for one thing. Many companies (as a result of this change in preference? …or is it vice versa?) are prized for their intellectual property, their brand names, their distribution networks, none of which appear on the balance sheet, but all of which give them a chance at superior future earnings growth. These firms, and their shareholders tend to think of dividend payments as a sign of weakness–that high dividends imply management has no better ideas about how to invest their money–rather than strength.

The academic world really has nothing meaningful to say about large parts of today’s stock market, in my view. There are consequences of the party line that stocks can be reduced to a funny kind of bond, however. If nothing else, this is because no one has come up with a comprehensive, simple-to-teach alternative to the present value discount models.

more tomorrow

El Salvador and bitcoin

El Salvador recently announced that it will accept bitcoin as well as the US dollar as legal tender in that country.

I initially read saw this move through a traditional post-WWII developing economy lens. The strategy, perfected by Japan and subsequently imitated around the world, was to make its primary economic tool a peg of the local currency to the US dollar–and leave everything else to fall out as it may. This move ensured that the export-oriented industries a country pinned its hopes to would not be undermined by currency movements. It also robbed local politicians of the ability to manufacture inflation to paper over operating problems powerful local industrial interests might have. At the same time, however, the peg tended to also usher in a period of general economic austerity–which could be blamed on Washington rather than past mistakes by the local government.

Over more than a half-century this strategy worked spectacularly well in Asia. Not so much in Latin America, though. There, governments have almost always, it seems to me, succumbed to pressure from powerful local interests hurt by economic transition to abandon the dollar peg before tangible positive results could be seen.

..which brings us to El Salvador, about which I’m far from being an expert.

My reading has been that El Salvador has begun to sour on the US dollar and has therefore turned to cryptocurrency as an alternate source of stability. El Salvador wouldn’t be alone in doing so. The Nikkei recently described how Trump’s attempt at violent overthrow of the government, and the continuing large-scale Republican support in Congress of this effort, have deeply shaken foreign confidence in the safety of US Treasury securities. To me, foreigners’ worries seem less about revolution itself than about the economic illiterate who would then be in charge. Their view appears close to what’s expressed in a recent Deadspin article about how Trump destroyed the XFL.

One of my sons has pointed out to me that this may be far too old-school. I may be overthinking the whole thing. One key aspect of El Salvador’s move is that in that country bitcoin is no longer an investment asset subject to capital gains tax. So the decision may have a much simpler motive. El Salvador may just want to become a tax haven for crypto firms.

stock market implications of a global minimum corporate tax (ii)

The S&P 500 gained just under 20% in 2017, the year the large cut in the US corporate tax rate was passed. The new law, which took effect on 1/1/2018, boosted US-sourced earnings by about 21%. In 2018, however, the index lost a little over 6%. That’s because, I think, the stock market began to discount the better earnings prospects as soon at it became clear that the law would pass.

The same will likely happen in the case of a global minimum tax as well. Only this time the effect will be negative, and likely most keenly experienced by companies who have placed the greatest reliance on financial engineering, rather than operations, to boost their profit growth.

It’s also possible that this will be the trigger for investors to once again begin to read a low tax rate as a bad sign for a company, and to adjust the PE multiple down because of this vs. full tax rate-paying competitors as they commonly did a generation ago.

It’s thinkable, as well, that deeper consideration of the information in corporate tax disclosures will lead to a more seismic shift in the assessment of company value of the kind that Warren Buffett caused a generation ago in his stress on the value of intangible assets–intellectual property, brand names, distribution networks…–that the market regards as obvious plusses today, but had ignored until Buffett came along.

There’s already a bit of worry in the air about managements losing touch with the nuts and bolts of the industries they compete in, focusing on propping up current earnings rather than on creating cutting-edge products. Witness investor dismay at the apparent loss of operational competence in once iconic names like Boeing or Intel or ATT. At the very least, in my view, the draining of the ocean of monetary stimulus we are now swimming in will force investors to discriminate more sharply between potential winners and losers as the cost of funding operations begins to rise. As I’ve mentioned before, the only environment remotely like the current one that I’ve experienced is the high-yen, low interest rate environment of Japan in the late 1980s. The early Nineties there were particularly ugly for hidebound traditional zaibatsu/keiretsu firms whose greatest merit was their being in the rising tide of the previous decade. I can imagine a similar changing of the guard happening here.

This would tilt the field of play away from factor investing and toward the more traditional skills of analyzing balance sheets and income statements, and projecting them forward.

stock market implications of a global minimum corporate tax (i)

1980s tax planning

I got my first job as the lead (and only) manager of a global fund in 1986. I’d worked for six years as an analyst and manager in the US market and for a couple in the smaller Asian markets. I knew my first task would be to understand Japan, then the largest–and hottest–stock market in the world.

Commissions and fees were high there, trading volume was enormous. At the same time, local brokers had no interest in foreign customers, whom they regarded as not fully human, and were analytically pretty backward anyway. So I was surprised to learn that virtually all the big international brokers operating in Tokyo were posting gigantic losses from their Japan business–high expenses, understandable given the high price of real estate and of imported goods like food, but low revenues. Then I learned why.

Corporate taxes were very high in Japan back then. So foreigners executed all their trades through their Hong Kong offices, where the corporate tax for foreign companies was zero.

today’s world

Ireland is the poster child of large-cap corporate tax avoidance because its corporate income tax rate is 12.5%.

How the shelter works:

–a non-Irish multinational bundles up its intellectual property–brand names, R&D…–, consolidates it in an Irish subsidiary and for its use around the world agrees to pay a royalty to the Irish sub.

–the firm has sales of $1,000,000 in Germany, where the corporate tax rate is 30%. Let’s say expenses, ex royalty, are $600,000, meaning pre-tax income is $400,000. The firm pays a royalty of $200,000 to the Irish subsidiary, however. This is another expense for German operations and cuts pre-income there to $200,000.

–in Germany, after-tax income is $140,000. The royalty income is taxed at 12.5% in Ireland, netting the firm $175,000. Total income for the firm is therefore $315,000. Without the financial engineering, total income would have been $280,000. Overall, good for the firm, good for Ireland, bad for Germany.

my experience

When I started on Wall Street, such financial engineering was frowned upon. Most analysts and portfolio managers at least mentally reduced the resulting earnings downward to remove the zaitech benefit. One prominent UK broker even made it a feature of its research to “normalize” earnings to reflect the home country statutory rate.

Two reasons for this:

–with US companies, at least, repatriating foreign earnings means paying US income on them, minus a credit for foreign taxes paid. So the financial engineering savings are in a sense stranded abroad and not available for capital investment here or for paying dividends to shareholders. Corporate lawyers have long since found ways to make the funds available domestically without incurring a tax liability, however. Dividends are no longer as important to Wall Street as they were back then. And the emergence of Trump and his acolytes as standard bearers for the Republican party has pushed the US way down the list of places companies feel comfortable investing in.

–the thought in the early days of financial engineering was that any such ploy would be short-lived because governments would quickly shut down corporate loopholes.

more tomorrow