The common misperception I get from my colleagues and friends is that with interest rates being at record highs, the no brainer investment strategy is to invest in more bonds since there is likely to be more downsides for equity.
To me that is one side of the coin. The stories you see on the news media over the last few months definitely paint a grim picture on the equity market. Especially as interest rates continue to rise, it will cause cost of operations for businesses that are funded using debt to increase. Notwithstanding other factors as well, such as inflation and supply chain disruptions. This resulted in much fear as people flock to safer investments.
This is where Warren Buffett’s words should resonate in our head, where we should be fearful when people are greedy and be greedy when people are fearful. With the interest rates continue to increase, not only are bonds becoming more attractive, equities are as well.
Website: Warren Buffett: Be Fearful When Others Are Greedy
To illustrate using hypothetical numbers, assume that the cost per share currently is $2.00 and the dividend is fixed at $0.12. The dividend yield would therefore be around 6.00%. With a risk free rate of 3.50%, this means the market risk premium of the investor is around 2.50%.
| Assumption for Equity | Data |
|---|---|
| Cost Per Share | $2.00 |
| Dividend | $0.12 |
| Dividend Yield | 6.00% |
| Market Risk Premium | 2.50% |
| Risk Free Rate | 3.50% |
Personally I like to use 2.50% as the market risk premium as that is more or less a decent good rental yield in Singapore. When buying investments, I see myself as a mini-landlord owning multiple different assets to generate passive income. Other investors may have different perspectives, and the market risk premium adjusts accordingly, such as for those technology companies trading at different multiples from Real Estate Investment Trusts (“REIT”).
Website: What is a Good Rental Yield in Singapore?
In the second part, we will now adjust the interest rate assumption of risk free rate. Assuming the market risk premium remains constant at 2.50%, the expected dividend rate will adjust as below.
| Interest Rate Assumption | Expected Dividend Yield |
|---|---|
| 3.00% | 5.50% |
| 3.50% | 6.00% |
| 4.00% | 6.50% |
With this new expected dividend yield, assuming there is no change of the dividend payout amount of $0.12, the cost per share will therefore adjust accordingly.
| Interest Rate Assumption | Expected Dividend Yield |
|---|---|
| 5.50% | $2.18 |
| 6.00% | $2.00 |
| 6.50% | $1.85 |
This means to say that once the interest rate decrease, it makes both the bond and equity less attractive to invest in. Since the bond rates are now lower than before and your purchase of share price will be higher.
Similarly, if interest rates were to increase, you will also lose out since your earlier investment in the previous bond is at a lower rate. If you had purchased equities instead, you will likely see some capital losses as well.
Unfortunately for most people, this means that when the interest rates were hiking at record paces, the best investment during this period would be to actually be cash so that you can add both bonds and equities at the best rates.
However, timing the market is never a good advice as well since most of us do not have a crystal ball for such predictions. What most of us should do instead is ensure we have sufficient cash on hand for our expenses, and only invest using money you are willing to lose. This way you can ride through any downturns.
The illustration above however also relies on too many factors to remain constant. Dividend can be affected by the profit of loss of your investments and market risk premium will adjust with the investor’s risk appetite. Thus take it with a pinch of salt.
Disclaimer: Not financial advice. All data and information provided on this site is for informational purposes only.
