How They Get You & How They Keep You Down
Interest Rates & Inflation are weird
Over the past two decades, the most risky and least risky investments in the world have both been beneficiaries of longer than normal periods of lower rates and inflation. This note focuses on our definitions of interest rates and how they affect pretty much everything. I’ll write a deeper dive into inflation in short order.
A Zero Sum Game
My own definition of interest rates is simple. Financial markets are a big zero sum game and interest is a simple measure of the price of that game. First, I’ll explain why I believe financial markets are zero sum, and then I’ll discuss my approach to determining the cost of participation in the game.
Interest rates are: “The price of money”
First, every financial asset for one party is paired with a financial liability for another party. It logically follows that payments from the first party are an expense, paired with a mirror image income to the second party. In total, these assets and flows net out and contribute nothing directly at all to global net worth.1 Wealth on the other hand is largely driven by real assets. Real assets are either natural, like land where food and fuel are sourced, or they are man made, like buildings, machines or, in recent decades, intellectual property. These real assets roughly align with the provision of what people want and they make up real net worth. Finally, real wealth follows population growth broadly because, well, every new human is new demand for things.
Now consider the second part about the price of the game, an interest rate is just the quantity produced from an equation where the numerator is the compensation paid by one party and the denominator is the value of total capital put at risk by another.2 One way to understand the assertion that financial assets contribute nothing on net, is to consider what happens when the issuer of financial assets defaults. The owners of those assets are typically worth less in that moment, only retaining the real assets which were controlled by the issuer prior to default. Conversely, the issuer is equally and instantly worth more upon default, as what it owes is exchanged for what it owns.
Interest rates are: “the annualized contractual return associated with a debt instrument”
Typically, the cash or real property, land or machinery that can be liquidated is worth less than the market value of what it owes to investors and that is why an entity enters bankruptcy.
As interest rates approached zero, so did compensation for risk. To the untrained eye at least, risk free things and very risky things started to look very similar. At the same time, some investors made incredible returns from “risk free” assets while others did not require a lot of compensation for taking eye-watering risks.
On September 20 2017, Austria’s Treasury, which serves to manage the debt of the Republic of Austria, issued 6bn Euros worth of debt. The bonds paid investors a rate of 2.1% annually until September of 2117. This is not a typo. almost 100 years after the landlocked country’s establishment prior to World War I, I guess the debt management office, who is responsible for funding a nation less than 1/8 the size of Texas with 1/4 the state’s GDP, decided to celebrate and secure money for another 100 years.
Given average global interest rates for developed market long term debt around 4.5%, this turned out to be very smart for them. There are reasons why the asset is useful for investors, but today owners of this asset now hold something that is collectively worth 3.6bn euros.3 This is from a high of 13.5bn euros in November of 2020, and we have to keep in mind that these securities are some of the safest investments in the world.
On one hand, I suspect buyers at the highs are either regretting this or just very happy they didn’t buy 30y GILTS. Even for the largest holders, which are supposedly liability driven investors, having a long term outlook means that earning 2.1% annualized return at a very low risk of default can be sensible and prudent. On the other hand, it is pretty bold to not sell that low risk asset, when it has gained 125%, effectively representing 60 years worth of income brought forward to today! One way to look at it is as follows:
You are a pension fund who invested 100 EUR in 2017.
At the end of 2020 you have two broad options
Sell your investment and collect 225 EUR
Hold your investment and wait to collect 310 EUR in 2117
In option (a), you have a problem - now you have 225 EUR burning a hole in your pocket in a low rate environment and you’re probably looking at a lot of things that earn less than 1%. At the same time you are responsible for future liabilities that have increased in (present) value. Fortunately, you get the benefit of knowing that you made 225% on your investment and you can use that to buy sandwiches (or pay pension liabilities.) Technically, you could put 125 EUR aside and hold very short term securities, but those yields are negative, so that is bad. So you sort of need to find something safe that earns about 1% in order to be in the same place by the time 2117 rolls around.
In option (b), you are taking a long term view, you have liabilities that are worth a lot more than they were worth in 2017 and those are closely linked to the value of these bonds, you are hedging for a purpose and you stay the course. It really looks like the safe option and inside this option there is also a little devil on your shoulder saying “LET - IT - RIDE!” maybe this thing goes to 300 in 2021… (half joking, investors do not think like this right!?) Nevertheless, many professional investors were offered a 125+% return on a risk free asset, but in the moment many blinked, knowing fully well what the outcome was going to be:
Earlier this year, I asked my friends to tell me their definition of interest rates. I spent almost 20 years of my life studying interest rate markets globally and trading securities affected by interest rates and foreign exchange and the only thing that I am certain of is that I still have a lot to learn. Increasingly, many market participants did not really care to define interest rates well, they were highly skilled at their jobs and superordinate members of society. Participants in rates markets could very easily spend time on the philosophy of interest rates or inflation, but rates were a means to an end and as they say, there are no pictures on the scoreboard.
I loved to trade and compete as much as the next person, but I also enjoyed trying to understand why. It was fun for me to understand that for some borrowers, the interest rate is just an expense to be managed over a long time because they borrow a lot and felt they would always be able to borrow, whereas for others it may be compensation for money they had put at risk which was critical to their livelihood.
“Temi, interest rates are how they get ya, and inflation is how they keep you down.”
The best answer came from a friend who neither studied economics nor was a professional participant in financial markets. He said “Temi, interest rates are how they get ya, and inflation is how they keep you down.” I could not have said it better.
Macroeconomics are complex because of the interactions between the factors that affect the value of a real or financial asset or the utility that participants place in them. When trying to make sense of this complexity, people tend to use models. But, all models can do (including macro models) is help you define the cash flows in the future, and/or the rate to discount cash flows back to today. I have written about this concept in the past, but today Austria is presented with a really interesting option
Buy back their entire 100 year bond and after all payments net approximately 1.64 billion euros, while saving themselves from 11.8 billion euros of residual interest payments4
Let it ride! The world can change quickly
Austria could execute one of the best trades of the Zero Interest Rate Policy era and I’m not sure if its wackier that most of the lenders did not sell at a 125% return or that Austria wont buy it back now!
Money for Nothing
If you were a sovereign bond fund manager from 2006 to 2020 you could have presented your investors with the following proposition:
Here is all your money back, I’ve made you a lot of money (rates down / bond prices up)
You should still pay me 1% on the today value for the next 5 years because I have literally made more money for you than can possibly be earned in the future from the assets I invest in.
In exchange for me saving you the pain of losses, call me when you’re ready to party again!
Obviously, this is a far fetched proposition, no-one is going to pay someone to not invest their money. But I think it could have been smart! With negative rates, the current prices of the assets in most sovereign bond funds were higher than the total future value of the cashflows promised, and destined to go from premium back down to par.
A more reasonable approach for bond investors could be to shorten the duration of bond portfolios. But I’m a (financial) zealot and I don’t like that approach because the main reason to keep owning bonds at that time was for “diversification.” Since prior to the financial crisis, bonds have not been uncorrelated against stocks at most tenors. The chart below shows this rolling correlation across time:
But why? As with most things economic, I’m not convinced there is one answer. But quoting the esteemed authors of this chart about the relationship between fixed income and equities: “The relative importance of growth and inflation news, therefore, suggests itself as a potential driver of the [Stock & Bond Correlation].”
Interest rates are: “the rate to borrow money adjusted positively or negatively for your financial acumen / stupidity”
I am certainly oversimplifying their analysis, but what they suggest is that it's not the actual level of growth and inflation that drives investment returns, but rather investors' perceptions of these factors and their relative importance. Theoretically, growth attracts capital to equity - which earns the increasing future cashflows of productive businesses. It also largely causes expectations for short term interest rates to rise as flows leave fixed income and drive down the price of bonds.
For entities confident in the future, this is how “they” get “you”, remember one person’s expense (interest) is another person’s income and higher rates paid today create real assets instead of financial assets for bond holders and reduce the real wealth of borrowers. Inflation on the other hand both diminishes the real value of cashflows, fixed or variable in the case of equities. You see, this is how “they” supposedly keep “you” down (again a topic I’ll cover at a later date).
The only way out is Through
The US economy has thrived for centuries by creating new things. Just as the core driver of the economy shifted from agricultural to industrial to the internet economy - the only way to continue the blessing that has been capital invested in the United States is for more new things. We need another letter and maybe a new acronym to add to FAANG because without it we may all suffer greatly.
While Austria was offering investors a safe way to earn a little compensation (a low interest rate), Start ups and certain other forms of capital formation were offering investors at the other end of the spectrum a risky way to earn high compensation ( a high interest rate). Highly risky and audacious enterprises were equally as large beneficiaries of ZIRP, and many unicorns were minted at the same time as governments borrowed (and spent) with no remorse.
All companies are a discounted cash flow (DCF) Model. The intrinsic value of a business is the discounted value of the future cashflows available to investors and even start ups with material current negative cashflows, are highly valued because venture investors believe that there are massive growing positive cashflows somewhere out in the future. Growth is quite important to them, and the risk of inflation all but disappeared for a decade.
An Interest rate is: what you are willing to receive or pay to take on certain risk for a certain period of time.
One way to think about it is that being a unicorn is actually easier when rates are zero. The present value of 1 billion dollars in 5 years when risk free rates were 0.25% was 987 million dollars. With rates at 4.75% the value of that same 1 billion is 783 million. This 204 million per billion is a representation of economic gravity and you cannot escape it unless you literally go to the moon or Mars.
What do investors need to believe about a unicorn in different rate environments? In a 5% environment, investors intrinsically believe companies will make 291 million dollars more than in a 0.25% environment. When comparing a 10% environment to 14.75% environment, investors need to believe the company will earn 439 million dollars more in the same 5 year span. 5 None would explicitly reduce their process to a DCF, but cash flow is literally required to create returns:
Ironically, a lot of the beneficiaries of this gravitational pull are true geniuses who aim to take us into outer space! If you take Tesla forecast EBITDA at 16.5bn, 21bn and 28bn in the next 3 years and apply a terminal value of Tesla at 1 trillion dollars,6 between March 2022 and now that terminal value is worth at least 200bn less. Tesla’s market cap went from 1 trillion to 726 billion today and I would argue, roughly 200 billion of that is just the effect of interest rates.
An interest rate is: “what $1 invested today will earn over time, with obvious distinctions for maturity, reinvestment etc”
Tesla itself is quite special, but I think in general high growth and high risk companies were the natural beneficiary of ZIRP. However, in an environment where the market’s relative weighting of growth begins to diminish vs the fear of inflation, and overall interest rate levels remain higher, things will change. Frequent borrowers like Austria may have less access at a higher expense and higher growth companies will need to actually earn what their investors require to survive.
Rates and inflation are macroeconomic’s own fundamental interactions and I think Howard Marks is probably right. The very interesting opportunities to look at now are neither low risk, high risk, nor high growth endeavors, but maybe companies with real and productive assets who are now paying 8%+ yields which can be compounded. We could also be on the brink of WW3 and do ZIRP again, which could be sad.
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Definitions
They contribute a lot indirectly by allocating savings to productive entities or people, but in and of themselves if those endeavors fail, nothing is created or lost in aggregate.
Terms like "interest rate," "return," or "IRR" are commonly used in finance, their precise meaning can be quite intricate. The methods for calculating them, rules for counting them, how they accumulate, their discounting, and when payments occur all involve a lot of detailed rules and considerations. To fully understand what these percentages mean, you often need a lot of additional information that most people ignore. But in general, in my humble opinion “interest rates” are the price of the big zero sum game that is all financial assets.
This ignores a few technical realities that will upset professional fixed income folks. The proliferation of fixed income funds means that funds like VTIFX, the largest international high grade bond fund, does not hedge this rate risk. They simply own this bond in so far as it is market cap weighted against a particular index and so they dont really care about the price. I really mean to question the behavior of active investors. A lot of credit funds only retain “spread” risk by selecting a benchmark or risk free bond to short for every amount of delta they have long - this would be challenging in this case given this is already a sovereign bond, in theory they could potentially sell some Bunds, but this would add other risks. Additionally lots of sovereign bond investors employ short term leverage to buy long term assets, hedge foreign exchange risk in a mismatched way (hedge fx for 3 months at a time), have structurally longer term liabilities or hedge using interest rate futures products. All of these things make it not strictly useful to look at the performance of this within a complex portfolio. One example would be a fund using 100mm of invested capital to borrow 900mm through deposit and collateralized financing agreements with a 7 day to 3 month term @ -0.5% in 2017, and 0% in 2021 through 2022 while pocketing coupons of 25.5 million euros a year (2.1% x 1bn minus -0.5% x 900mm) which is great! While suffering only -15mm euros of losses per year ( 2.1% x 1bn minus 4% * 900mm) today. This asset could still be a great carry trade.
Austria borrowed 6 billion euros, paid a historically low price, 2.1% per year for money for 100 years. They have paid 756 million euros of interest payments over time and now they could theoretically pay 3.6 billion euros to remove their 100 year obligation netting 1.64 billion euros on the round trip and saving themselves from 11.8 billion euros of residual interest rate payments.
This is a very dumb and simplistic way of looking at it with linear growth, which is uncommon for these types of businesses, but I dont think it would make a difference.
I have just assumed a 13% terminal discount rate and a 10% growth rate and the market forecasts - this is too complicated for me to do accurately and it would not change the point if i used the correct numbers. Many studies have shown that changes in cashflows need to dominate changes in discount rates in order for equities to perform.