The changing market environment due to expectations that the Bank of England is likely to hike UK base rates by around 0.75% at the MPC meeting tomorrow, means that asset allocation strategies within multi-asset funds are under review. Russ Mould, AJ Bell investment director, takes a look under the bonnet, at how changes in interest rates affect share prices and, thereby, valuations and asset allocation strategies as he comments:
“The return available on cash, and by extension the risk-free rate available on government benchmark bonds, sets the reference point by which the attractiveness or otherwise of all asset classes will be judged.
“For much of the past decade, bullish investors have argued that share prices should rise because record-low interest rates and record low government bond yields, meaning that ‘There Is No Alternative’ (TINA). To try and get any sort of return on their cash, they have had to look to different and more risky assets.
“The yield offered by a government-issued bond is usually seen as the risk-free rate for investors in that country because. The last time the UK defaulted was 1672 and as such as the ten-year UK government bond, or gilt, is seen as the risk-free rate for UK investors.
“Any other alternative investment carries more risk so the investor should demand more from them – investment-grade corporate bonds should yield more than government bonds because companies can and do go bust, for example.
“The returns demanded by an investor to compensate themselves for the additional risks involved will therefore, in theory, move relative to the gilt yield.
“If a central bank is raising interest rates, then the yield on existing government paper will look less attractive. Investors will sell them and look to buy newly-issued gilts, which will have to come with a higher yield to attract buyers.
“This increase in yields on government debt means the returns that investors should demand from other, riskier options, should also increase
“For shares, it means paying a lower valuation, or multiple of earnings and cashflow, and also perhaps demanding a higher dividend yield (which is achieved by buying at a lower share price).
“There is another way in which interest rate movements affect share prices and equity valuations and this is the more complicated version of the PE ratio. This is the discounted cash flow (DCF) calculation.
“DCFs tend to be used for companies that have relatively predictable cash flows, or long-term secular growth prospects. They are also used for young, early-stage firms that are seen as capable of generating profits some way out into the future.
“This may be why a lengthy period of low or even negative bond yields prompted a huge uplift in the valuation of perceived growth companies, such as tech and biotech stocks, during the past decade (and especially in 2020 to 2021). The problem now for holders of this sort of company is that the opposite effect is kicking in, at least for now.”
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