Who Wins with Low Interest Rates?

Grim as things seem, most of us are in better shape than we’d be in a higher rate environment. Before inquiring about the strength of the product purchased from my local cannabis outlet, let me explain.

In 1873, Walter Bagehot famously wrote, “John Bull can stand many things, but he cannot stand two percent.” In other words, when the yield on consols – perpetual British government bonds – fell to that intolerably low level, frustrated investors sought out more speculative securities sporting higher yields, to their eventual regret. (More than a century later, Legg Mason analyst Raymond DeVoe would offer a more pungent assessment: “More money has been lost reaching for yield than at the point of a gun.”)

At the times of both those assessments, safe bonds yielded, well, 2% real returns, a rate that is a delicious distant memory. Today’s real rate of return of government securities, as judged by the TIPS yield, runs from -1.74% at five years to -0.35% at 30 years. The retiree who relies on a ladder of them – until now, the gold-standard method of defeasing a steady stream of liabilities – will suffer a slow, steady erosion of their spending power, likely until the day they die.

Throughout the land the cry is heard, “Where can I go for yield?”

The swift and brutal answer to this question is, of course, “nowhere”: One can reach for yield by taking credit or duration risk, and likely suffer the grim fate foretold by Bagehot and DeVoe, or else monetize one’s mortality with an annuity, thus sacrificing command of the assets and risking the possibility of pushing up the daisies quickly enough to lose most of the corpus.

I say, don’t worry, be happy.

Consider the counterfactual of historically “normal” interest rates. In such an environment, equities would surely be selling at much lower prices. How much lower? Consider this plot of the Shiller CAPE versus the10-year Treasury over the past 15 years:

Cast your gaze to the right side of the graph, and you’ll see that at 10-year yields of around 4%, CAPE ratios average in the mid-20s; as this is being written, it is just shy of 40: look out below! Will Treasury rates ever rise again to that level? Beats me, and besides, that’s not the point, which is to be careful what you wish for; to the extent that your portfolio is exposed to equities, you have far more assets than you’d have at higher bond yields.