A 4.69 Percent Ten Year Reprices Things That Never Changed

One Number Sits Underneath All the Others

The ten-year Treasury bond yielded 4.69 percent at the end of July. The two-year yielded 4.33 percent

Of the two the ten-year is the one that silently sets the price of most things. It is the reference rate at which a corporate bond is priced the anchor at which a mortgage is priced the discount rate that appears in valuation models and the return available for not taking on any credit risk for a decade

Most market commentary treats it as a thermometer for what the Fed will do. That's the smaller half of its job. The bigger half is that it's the number by which each future dollar is divided and moving it changes the value of everything without making anyone's business better or worse

What a Discount Rate Actually Does

An asset is worth the cash it will produce adjusted for the fact that a dollar that arrives later is worth less than a dollar that arrives now

The adjustment is not a matter of taste. A dollar today can be invested at the current exchange rate and become more than a dollar later so a dollar promised later must be worth less than a dollar in hand and the lower amount is set based on the current exchange rate

This is why a change in the discount rate revalues ​​assets that have nothing to do with each other. The building the software company and the pipeline share no customers or industry and all three are claims on future cash. Change the rate at which future cash is converted to present value and all three move together which is exactly what happens in a rate-driven liquidation and why it feels so indiscriminate

The Perpetuity Test

The cleanest way to feel about the arithmetic is the simplest possible asset: something that produces a dollar a year forever. Its value is one divided by the discount rate

At 2 percent that flow is worth 50 times your annual payment. At 3 percent 33.33 times. At 4.69 percent 21.32 times

If you go from 3 percent to 4.69 percent the same unchanged dollar per year is worth 36 percent less. Nothing changed in the dollar. No client left no margin was reduced no competitor arrived. The rate moved and with it a third of the value went

That single calculation explains more about asset prices in recent years than most of the commentary written about them. It also explains why the same analysts who spent a decade justifying high multiples are now justifying lower multiples with the same models. The models didn't change. The denominator did

Ten Years Out, in Today's Money

Perpetuity is a useful and slightly abstract example so opt for a one-time payment. One dollar will arrive in ten years

At 2 percent that dollar is worth about 82 cents today. At 4.69 percent it is worth about 63 cents

Almost a fifth of the current value of a payment a decade from now disappears with that move and the effect worsens the further you go. A payment that arrives in year twenty loses proportionally more than one that arrives in year ten which is the mathematical reason why companies whose profits are in the distant future are the ones that are hurt the most when rates rise

Duration Is the Word for the Sensitivity

Bond investors have a time frame to determine how much a price moves when the rate moves and it pays to borrow because it applies to stocks too

Duration measures the weighted average time in which cash arrives. A bond that matures next year has a short duration and barely moves when yields change. A bond that matures in thirty years has a long duration and moves a lot

The same logic applies to companies. A mature company that pays out most of its cash now has a short duration. A company that is expected to lose money for five years and then become highly profitable has a very long duration and its price is much more sensitive to ten-year performance than to anything that happens in its own industry this quarter

The practical consequence is that a portfolio can be enormously exposed to interest rates without owning a single bond. Anyone who has had a concentrated position in early growth companies in recent years discovered this and usually discovered it in the form of a drawdown that had no obvious company-specific explanation

The Refinancing Arithmetic

The other half of the level is what it costs to borrow and here the arithmetic is even simpler and the consequences more immediate

Take as an example a company with an overdue debt of 100 million dollars. If the original loan cost 3 percent the interest bill was 3 million a year. Refinanced at 6 percent it is 6 million. The company has not borrowed another dollar nor has it changed its business or done anything wrong and 3 million dollars of annual profits have been transferred to its lenders

For a company that makes 30 million a year that's a tenth of its profit. For someone that makes 6 million that's it

What makes this dangerous is the timing. The cost does not arrive gradually as rates rise. There comes a day when the old debt matures in full and until then the company reports the interest cost of the loan it took out years ago. Therefore a period of rising rates produces a queue of companies with bonds listed at a different time each of which revises its prices on a specific date that can be checked in advance

Therefore anyone evaluating a leveraged business at these rates should read the maturity calendar before the income statement because the income statement describes the old world and the maturity calendar describes when the new arrives

What the Two Year Adds

The two-year note at 4.33 percent is doing a different job and reading it together with the ten-year note is more informative than reading either one separately

A two-year yield is close to the average market expectation for the policy rate over that period. A ten-year yield contains that expectation plus a view on growth and inflation over a much longer horizon plus compensation for the risk of holding an asset long-term

The gap of around 36 basis points where longer maturity pays more is a modest positive slope. He says the market is being paid a little to accept a decade of uncertainty instead of two years

What it doesn't say is that relief is coming. A short-term rate that is expected to fall sharply produces a two-year yield well below the current policy rate and that is not the setup on offer. The bond market is pricing these rates at roughly the level where things stabilize which is a harder assumption to make a plan for than an easing cycle or an obviously temporary spike

The Squeeze on the Premium for Taking Risk

The last consequence of the level is what determines how much it matters

Owning stocks instead of government bonds should pay a little extra because shareholders are the last to get paid and can lose everything. That extra is the premium for taking on the risk and is measured by what the risk-free alternative offers

Cuando la alternativa libre de riesgo no paga casi nada casi cualquier rendimiento esperado sobre las acciones parece una gran prima y ​​el capital se ve empujado hacia el riesgo por la ausencia de otro lugar adonde ir.Cuando paga un 4,69 por ciento durante una década sin riesgo crediticio la comparación es genuinamente competitiva y cada activo riesgoso tiene que superar un listón que no existió durante la mayor parte del ciclo anterior

This is the mechanism behind the phrase that there is an alternative. It is not a slogan about sentiment. It is an arithmetic statement that the hurdle rate for deploying capital into something uncertain has increased by several percentage points and that a large number of investments that cleared the old hurdle do not overcome the new one

Why the Level Took So Long to Bite

One puzzle worth addressing is why an economy full of borrowers absorbed a big rate hike without the damage coming in time. The answer is that most of the debt was already secured

A household with a long-term fixed mortgage taken out at a low rate is not affected by an increase until it moves. A company that issued ten-year bonds during the cheap period is paying the old coupon regardless of where yields go. In both cases the exposure exists and is deferred and the deferral can last for years

What that produces is a transmission in slow motion. Policy tightens the average interest cost across the economy barely moves and the conclusion is that rates are not working. Then maturities arrive on their own schedule borrower by borrower and the cost of the new regime is imposed on each one individually whatever the rate in effect on that date

The uncomfortable feature of this pattern is that the pain is carried backward rather than avoided and is concentrated on the one who borrows for the shortest possible time. The prudent borrower who paid off his debt for a decade is fine. The one who finances short terms to save money on coupons appreciates immediately and repeatedly

It also means that aggregate statistics underestimate the exposure that is yet to come. The average interest cost in an economy is a weighted average of old and new borrowing and will continue to rise for years after the last rate increase simply as old debt is phased out

How I Use the Number

I try to check what discount rate is implied in any valuation before arguing about the forecast because the two are often confused. A disagreement about whether a company is worth 20 or 30 times earnings is often not a disagreement about the company at all. It is a disagreement about the rate and can be resolved much faster if both sides say what rate they used

I also perform the crude version of the perpetuity test on anything expensive. Dividing one by the current ten-year yield gives a rough multiple that flat cash flow could justify and anything trading well above that value is valued based on growth and not based on the cash it produces now. This is not an objection and clarifies which assumption is doing the work

And I read the maturity calendars earlier than before. When debt is not going to get cheaper on its own the date on which a company has to return to the market is a concrete fact about its future that anyone can consult today

Two Objections Worth Taking Seriously

The main weakness is that treating the ten-year period as the discount rate for everything is a simplification and in some sense misleading

The rate that matters for an individual asset is the government's yield plus a spread for its own risk and that spread moves independently. Credit spreads can narrow as government yields rise leaving the real cost of capital for a borrower unchanged or lower. A market where risk appetite is improving can absorb a higher base rate without anything effectively becoming more expensive

The other objection is that the above arithmetic assumes that cash flows themselves are not affected by the rate. In reality rates rise for reasons and if the reason is that the nominal economy is warming then income and profits are also rising. Discounting a rising stream at a higher rate is a different calculation than discounting a fixed stream and the naive version exaggerates the damage

Both objections are real. Neither eliminates the central point which is that a substantial part of what happened to asset prices in recent years was arithmetic rather than analysis

The Bottom Line

A 10-year yield of 4.69 percent isn't primarily a sign about the Fed. It's the number by which every future dollar is divided and moving it from 3 percent to 4.69 percent subtracts 36 percent from the value of a flat cash flow without making business worse. The same measure turns a $3 million interest bill into a $6 million one on the day the debt comes due and puts a genuinely competitive risk-free yieldin front of each investor who decides whether or not to take any risk. Check the discount rate before discussing the forecast and read the maturity schedule before the income statement