Why higher interest rates may be a gift for young investors
The era of easy money is over. Since the global financial crisis of 2008 until mid-2022, the US ten-year yield ranged between 2% and 3%. In the last six months alone, the yield increased from 4% to nearly 5%. The ten-year rupee bond yield also increased in the last six months, from 6.7% to 7%. Globally, it is a similar story. Bond yields are up in nearly every major country.
High bond yields indicate that borrowers are competing for investors’ savings. Borrowers are offering higher returns to convince investors to part with their money. This is in stark contrast the last two decades. During the period of easy money, investors struggled to earn a return greater than inflation from safe assets.
There are competing reasons for rising yields. It is driven by a combination of three things. These are higher expected inflation, higher expected growth, and changes to monetary policy. Current US Fed Chair Kevin Warsh has been critical of easy money policies. And US monetary policy affects bond yields globally.
What is a young investor?
In today’s article, I will focus on why rising bond yields are good for young investors.
First, what do I mean by a young investor? A young investor is someone in the phase of life where they are actively growing their portfolios. Their current assets are low, but their incomes are high. A young investor has a long investment horizon.
In contrast, an old investor is close to drawing down their assets. They may be near retirement or currently retired. Their current assets are high, but their incomes are low, or soon to be low. An old investor has a short time horizon. Naturally, many of us are in between these two extremes.
The two effects of higher yields
When bond yields go up, there are two effects. First, future returns are higher. If you buy a bond, you now earn a higher return than before. But bond yields also affect returns on other assets. Historically, stocks outperform bonds over the long term. If bonds are earning more, stocks will also earn higher expected returns. The caveat of course is that stocks are riskier than bonds.
Higher future returns are naturally good for young investors with a long-time horizon. It means greater wealth in the future. For old investors, it is less consequential. They will not benefit as much from higher future returns.
The second effect of higher yields is that current stock and bond prices go down. This relationship is mechanical in the case of bonds. Yields and prices move in opposite directions. In the case of stocks, it is a similar logic. The value of a stock is the present value of its expected future cash flows. When yields rise, the discount rate goes up. When cashflows are discounted at a higher rate, prices go down.
Stock and bond prices going down affect the market value of portfolio today. For a young investor with low current assets, a lower portfolio value has limited impact. For an old investor with high current assets, a lower portfolio value has a large impact. This is especially so if the investor is retired and periodically drawing down his portfolio.
The Mechanics of Wealth Transfer
If bond yields remain elevated or continue rising, stock prices will fall. This means lower sale proceeds for old investors. It also means good buying opportunities for young investors. We can think of this a transfer of wealth from those who own assets, to those who are accumulating assets.
This process is reversing what happened in the recent past. After the financial crisis of 2008, central banks around world kept interest rates and bond yields artificially low. Central banks engaged in non-traditional policy tools to do so. Examples include asset purchases and forward guidance.
The effect of that was the opposite of what’s happening now. It resulted in higher asset values, and lower future returns. It hurt young investors but helped older ones. The COVID-19 pandemic is a good example. Following a global market crash in March 2020, monetary easing went into full swing. By the end of 2020, stocks had recovered all their losses. Thus, those with large portfolios were protected. At the same time, bond yields fell dramatically (the US ten-year yield was less than 1%). This meant low future returns for young investors.
And today, we are witnessing the unwinding of these effects. It turns out that wealth redistribution from young to old is an unintended consequence of easy money. And now, with the era of easing money coming to an end, this effect is reversing.
Disclaimer:
Note: The purpose of this article is to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly encouraged to consult your advisor. This article is for strictly educative purposes only.
Asad Dossani is an assistant professor of finance at Colorado State University. His research covers derivatives, forecasting, monetary policy, currencies, and commodities. He has a PhD in Economics. He has previously worked as a research analyst at Equitymaster, and as a financial analyst at Deutsche Bank.