The low interest rates, their consequences & the returns of assets as an investment selection criterion

In EU member countries (e.g. Denmark, Germany) commercial banks are proceeding to mortgage loans with a negative lending rate. In other words, these banks grant discounted housing loans to borrowers and since the repayment of the mortgage loan not only will not be paid interest, but the borrower will repay capital in total less than the capital borrowed.

by Thanos S. Chonthrogiannis

©The law of intellectual property is prohibited in any way unlawful use/appropriation of this article, with heavy civil and criminal penalties for the infringer.

The fact that at global level the interest rates of the main central banks are at the same time at almost zero and/or negative level is clearly due to a high degree of surplus liquidity that exists globally. In addition, due to these very low and/or negative interest rates indicated that a concerted effort is being made by the main central banks of the planet to direct and induce a continuous flow of investments in order to support the growth rate of the global economy.

In this concerted effort began to enter from yesterday and the FED with the reduction of its basic lending rate from 2% to 1.75%, announcing at the same time its CEO that if necessary the FED will implement a series of reductions in its interest rates with aim to support the global economy.

On the other hand, at global level there is increased investment hesitancy for risk-taking, mainly because of trade and monetary wars, geopolitical developments and oil price turmoil, indicating that the efforts by the central banks have so far not been given the desired results.

The negative consequences of the low/negative interest rates

 In a world characterised by investment hesitancy, negative interest rates affect:

  • Saving in all its forms. This is because savings in an environment of negative and/or zero interest rates pose risks to depositors/savers because savings funds cease to be productive for depositors. The accompanying risk level in savings is a component of the size of the savings capital, the expected yield, the duration of the savings, etc.
  • So, given the above consistency (1), most people will pull out their savings and try to direct them to other types of investments in the main direction to the housing market because the property as an investment includes the lower investment risk.

Due to the constant flow of funds from savings to the real estate market, property prices over time will increase. In this way, the profit that will be achieved by the monthly installment of the mortgage loan due to the negative borrowing rates will be vanishing due to the need for higher borrowing amount (due to increased property prices) or will be required higher amount of funding from the borrower’s own resources.

  • The deposits by companies in banks will be punished with varying charges which over time will increase. In future the same will happen in the deposits of individuals. The aim of this “punishment” is for companies to pull out their funds and invest them. Investments, however, due to the high risk in the world level, reduce the size of actual yields.

How asset yields are used as an investment selection criterion

Each financier and more generally each investment advisor knows that the basic criterion of an investment either this investment takes place in stock  markets  or in the capital markets or in the real estate markets or in the market of business, etc. is that “the  asset  prices  should  equal  the  expected  discounted  cash  flows”.

This is the basic principle that determines whether a market is efficient, given that the efficiency of a market is based on whether its prices and incorporates correctly in the asset prices all the new information related to future cash flows of these assets.

At the same time the expected discounted cash flows indicate the risk preferences of investors. Having always as a guide this basic principle that is, «the asset prices should equal the expected discounted cash flows» can be said:

  • Where stock prices are at high levels in relation to earnings or dividends (i.e. yields are low), shows that future cash flows are expected to increase rapidly in the future.
  • When stock prices are at low levels compared to earnings or dividends (i.e. yields are high), shows that future cash flows are expected to be reduced quickly in the future.

However, the present value of these expected cash flows depends on the discount rate (which shows the risk profile of each investor) which the investors apply in the valuation of future cash flows (earnings).

In the field of business investments/projects this discount rate is the weighted-average cost of capital (please, see the glossary). This discount rate, which is different in size due to what each investor believes for the future, is the basic explanation of the volatility of stock prices.

In this way, if the stock prices are high and the yields are low the investors can accept lower-level returns in the future and vice versa. In other words, the yields are the mechanism to predict expected returns on assets.

How accurate is the predictability of government bond yields in terms of expected returns

To answer this question, we should check:

  • The actual annual performance of government (Treasury) bonds by looking at their historical figures and then we should compare this performance in relation to the yield-to-maturity that It arises respectively from the index-linked Treasury bonds.

 

  • Expected cash flows from stocks do not present the same degree of certainty as the corresponding expected cash flows from government bonds. That is another reason of why government bonds are generally characterised as the safest investment in transferable securities.

 

  • High stock prices relative to dividends, have indicated many years of poor returns. Low stock prices relative to dividends, have preceded high returns.

To properly predict stock returns as well as the dividend yields the valuation method, we will have to use on the stock will be based on the company’s aggregate earnings or book value.

But here it needs attention because many companies use the share-buy-backs strategy to return funds to their shareholders instead of paying dividends. For this reason, many investors use the earnings yield as a tool for forecasting stock returns.

This is because many companies do not use their company’s earnings to distribute capital to their shareholders in the form of dividends  or  share  buy-backs  but they reuse them by investing them in the company itself in order to create rapid growth in the company and greater future growth of earnings.

  • The successful investor is characterized by the fact as to whether it achieves accurately to predict when it should sell at high prices assets and buy back assets at low prices. In other words, if he is successful to catch turning points profitably.

Therefore, if yields predict returns, then the investors can sell stocks when yields (expected returns) are low and buy stocks back when yields (expected returns) are high. But in practice, this type of forecast-signal does not work well.

If the investor is short runner in terms of profits, he will try to use this tool of profitability turning points.

If the investor is long runner in terms of profits, he will interest how much extra cash the stocks will return to him over the safe investments (government bonds) in the long run.

  • This extra cash (extra reward) in the long-run over the safe investments is indicated by the Equity risk premium-the discount rate. In other words, the equity risk premium is equivalent with the expected return on equities. This risk premium for US equities is given by the following equation.

Equity risk premium = S&P 500 earnings yield – real 5-year Treasury Bond yield

To estimate the equity risk premium for an individual stock you must replace the S&P 500 earnings yield in the above equation with the individual stock earnings yield.

The higher the risk premium on stocks, there are more probabilities that the investors to decide to tilt their portfolios away from government bonds and vice-versa.

Those investors which have a long-term perspective on their investments might find more profitable to use this measure-tool (equity risk premium) in order to construct an investment portfolio based on a mixture of risky stocks and government bonds (safe investments) and a percentage in cash.

The housing markets

The same approach can be used in the real estate market. Specifically, when the demand for housing is strengthened, the rents are reinforced respectively (in this case the rents and the sale value of property are the expected returns from an investment on property).

The main reasons for boosting demand are, long-term maintenance at low levels of borrowing rates, increased employment rate and population growth due to internal or external migration.

The housing market for the purpose of its exploitation through rental is a popular investment activity that pays off when bank lending rates are low and the returns from the financial markets are uncertain.

When the real-estate market is depressed and it is difficult to sell, it is quite difficult to rent.

When the real-estate market is on growing market prices and it is easy to sell, it is easier to rent.

The yield of the property through its rental is determined by the following type:

Yield of the property:

= [(Income from rental–property expenditures–taxes) /Value of property]*100%

This yield of property is used to compare with the returns (yields) of other types of investments from stocks, government bonds, etc. This yield of property which comes from rental activity looks very much like the interest rates that Banks and Building Societies used to quote in savings and performance accounts equally and other type of investments etc. and gives a useful insight into the return on investment.

In order an investor to evaluate in the long-run the extra cash (extra reward) over the safe investments (government bonds) he must use the Real estate risk premium-the discount rate. In other words, the real-estate risk premium is equivalent with the expected return on property. This risk premium for US real estate market is given by the following equation.

Real estate risk premium = MSCI REIT index total return – real 5-year Treasury Bond yield

To estimate the real-estate risk premium for an individual property you must replace the MSCI REIT index total return in the above equation with the individual property yield (estimated in the above formula).

The higher the risk premium on properties, there are more probabilities that the investors to decide to tilt make an investment on properties and away from government bonds.

 

 

 

 

 

 

 

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1 Comment

  1. Why are the commercial banks are proceeding negative lending rate?
    Thank you.

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