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Higher rates mean lower asset valuations

Published on 01-20-2023

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Getting used to the new valuation math


“Sometimes,” Paul Simon once declared, “when I’m falling, flying or tumbling in turmoil I say ‘Whoa, so this is what she means.’”

We’re not bouncing into Graceland. It’s more like just trying to navigate our way through one of the trickiest credit markets of a generation. The December holidays that feel long ago now offered a welcome period to read, think, and reflect upon the situation we face as the calendar starts anew.

Here are some thoughts for this moment…

Getting used to the new valuation math

At the end of 2022, the U.S. two-year yield sat at 4.43%. Historically, that is an unremarkable level. Since June 1976, the average two-year Treasury yield has been approximately 5%. However, in the context of recent history, a two-year yield in excess of 4% should be compared perhaps with Mount Everest appearing suddenly on the Saskatchewan prairie. It is simply the highest yield in more than 15 years, a period during which, most of the time, short government paper paid less than 1%.

Treasury yields are important generally in finance because risk-free interest rates are situated in the denominator of asset valuation equations. And there, just to the right of the bracket that holds the risk-free rate, is an exponent, which makes the impact of higher underlying yields, well, exponential.

In short, higher rates mean asset valuations should be lower. What assets, you ask? Pretty much all of them. Bonds? Check. Houses? Check. Stocks? Check. Private companies? Check. The business collateral that supports any credit investment is, on the margin, worth less in a higher rate environment than it is in a lower rate world. If we owned a bond last year in a hypothetical $3 billion company with debt of $1 billion, then, all other things being equal, that $3 billion company might be fairly valued at $2.5 billion now. And that clearly reduces the buffer of value below our credit position.

The “new math” for us creates an incentive to move higher up the capital structure, or into structures that have more buffer value below the debt. It also causes us to value companies with cash flows expected in the near term higher compared to those companies with cash flows that arrive in a distant future.

Getting used to higher all-in yields

While lower valuations are a tough pill to swallow, an offsetting benefit of the current environment is a higher all-in yield available across the credit markets. The Pender Corporate Bond Fund starts 2023 with an average yield to maturity of approximately 8%, significantly higher than the start of last

In addition to the obviously higher running returns, a higher yield structure also offers a benefit in terms of being able to absorb any further rise in rates. A five-year bond that yields 1% suffers a -2.5% total return loss if its yield increases by one percentage point. But a five-year bond that yields 6% still provides a total return of 2.5% if its yield rises one percentage point

Thinking ahead: Which issuers can pay higher yields? The sudden rise in interest rates also raises concerns about general credit quality. Here is a simple example: A person borrows $1 million to buy a house at a 2% mortgage rate. The annual interest cost was initially $20,000. Now, with higher rates, the mortgagee must refinance at 6%, increasing their annual interest costs to $60,000. What happens if they cannot afford to pay an extra $40,000 in interest costs?

Now take that problem and consider the following: Pretty much every stock and bond issue, every housing purchase, every business acquisition, virtually every significant asset purchase in the last 15 years, was financed in the context of a much lower interest rate environment. We recognize that Warren Buffett can handle 6% rates. But not everyone is Warren Buffett.

This is why we expect the impact of the Fed’s hiking to have a broad effect, reduce consumer demand and create debt service pressure across the economy in 2023. This is also why we expect risk-free yields to come down, at least temporarily, as a slowing economy quashes inflation and enhances demand for well-covered, liquid debt securities.

Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income Manager’s Commentary, December 2022. Used with permission.

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