The Discount Rate: Borrowers, Lenders and Bonds

Reddit

Your Neighbour is Running Your Retirement Fund.

Would you trust your neighbour’s judgement when it comes to your retirement?

Bad news: You already are.

You see, the thing that keeps stock prices up is the buying pressure created by people who are not yet invested. Do you trust your neighbours to be smart enough to bid up the price of the shares you already own? And if they have already followed your wisdom and bought the stocks you happen to own, do you trust them not to sell out before you make off with the capital gains?

These questions matter a lot because of how your neighbours’ perceptions might change in coming years. They will get older. And they will face a different economic environment. Add these changes together and you get quite a shift. One that could ruin the prospects of capital gains for years to come.

Here’s why.

The Secret of the Discount Rate

The discount rate is what finance professionals use to measure the difference in value between a dollar today and a dollar in a year’s time. So what’s your discount rate? Well, if I offered to give you a dollar today for a dollar and five cents in a year’s time, which would you choose? How about a dollar and ten cents? $1.50?

If your tipping point was at a dollar and five cents, that makes your discount rate 5%. $1.50 is a 50% discount rate. In other words, your discount rate is the rate of return you require to put off receiving the money now. Young people want to spend money now, so they have a high discount rate. Middle-aged people tend to save, so they have a low discount rate. And old people don’t need to save, so they have a high rate.

What’s interesting about two people with different discount rates is that they can do business with each other. If the person with a discount rate of 5% lends the dollar to the person with a discount rate of 50% at an interest rate of 20%, both are happy campers. The person who really wants the dollar today is willing to pay the person who is happy to get it later for the service of allowing him to use the dollar in the meantime.

This rather odd concept explains why we have borrowers and lenders in an economy. A difference in discount rates makes it beneficial to borrow and lend. And the fact that everyone is better off explains why so many do it.

Neither a Borrower Nor a Lender Be

But the concept also has another implication, which is far more practically important to you and the capital gains you might expect. Imagine a five-year bond with $100 par that pays $1 a year coupon. That means you pay $100 to buy the bond, receive a payment of $1 each year for five years, and then receive back the $100.

Logically speaking, this bond would be worth $105 if you tried to sell it shortly after it was issued. Because it represents a cash flow of $105. Five interest payments of a dollar and a final payment of $100. But remember, cash flow in the future isn’t worth as much as cash flow today. And the discount rate is what calculates the difference.

So how much would the person with a discount rate of 5% be willing to pay? We won’t get into the math, but this bond price calculator says $122.08. (It’s probably calculating a semi-annual coupon payment, but let’s ignore that.)

A person with a 50% discount rate would be willing to pay $26.91 for the bond. That’s less than a quarter of what the person with the 5% discount rate is willing to pay.

But do people really pay more or less than $105 for a $105 cash payment? It seems ridiculous, right? The difference is because future cash payments are far less valuable to the person with a 50% discount rate – they want their money now. And expect to be compensated with a higher return if they are going to forgo it for a period of time. By bidding a lower price, they get that greater return.

But here is the big point we want to make. If the discount rate of the market as a whole rises, meaning people want their money sooner, then the price of assets (such as bonds) fall.

Just to be clear, when discount rates change, it has nothing to do with the risk of individual investments, or their expected return. It is simply personal preferences changing. People want their money sooner, and so require a bigger benefit to part with it.

That doesn’t just apply to bonds. You invest in shares under the understanding that you will sell them at a certain price, possibly with dividends. It’s the same stream of payments, just not as certain.

What you’ve got to remember is that it’s people’s personal perceptions that drive a vast part of investing, not just fundamentals of the shares and bonds. If people demand a higher rate of return on their investments to part with their hard-earned cash, assets have to fall in price to match that required return. Nothing about the investment itself needs to change for the price to fluctuate.

Now, where does that leave a world with a demographic and sovereign debt crisis on its hands? Do you think people will happily invest their money in long-term projects for the future, or will they hoard it jealously, requiring higher and safer returns to part from it? Our bet is the latter. Which means rising discount rates, or higher levels of required return for the same level of risk. That, as the bond example showed, implies a long and drawn out crisis as far as capital gains are concerned.

What is remarkable right now is that the opposite has been happening. People are crowding into lower return assets, seemingly lowering their discount rates. In America, people are theoretically willing to invest in bonds for 10 years that will yield a return of just 2.25%. Most of them probably don’t expect to hold the bonds for 10 years, which is where things get interesting.

One of the reasons why investors are, for now, jumping into safe government bonds is that investing is a question of alternatives. If you don’t put your money in supposedly safe bonds, you have to put it elsewhere. And most of those ‘elsewheres’ do not have a defined par value – a defined payout at the maturity of the investment.

But that’s for another day.

Regards,

Nick Hubble
for The Daily Reckoning Australia

From the Archives…

Why BHP Should Be Bracing Itself For a China Slowdown
2012-03-30 – Greg Canavan

What Does “the Market” Mean to You?
2012-03-29 – Joel Bowman

Why Australian House Prices Are Set to Crash
2012-03-28 – Dan Denning

Why US Manufacturing Could Be Made in America…Again!
2012-03-27 – Chris Mayer

The Best Real Estate Bets
2012-03-26 – Eric Fry

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
Reddit

Leave a Reply

4 Comments on "The Discount Rate: Borrowers, Lenders and Bonds"

Notify of
avatar
Sort by:   newest | oldest | most voted
Ross
Guest
Or you could buy into the financial malarky of the annuity ads guarantees. CGF & APRA, tick tick tick… Anyone else hear that we are going to anchluss NZ? The great Aussie bailout to recreate the Ozzie one in re-unified Germany with a currency union. All that RBA-APRA disgrace in creating an NZ property bubble off AU bank balance sheets in another currency and buying into currency and interest rate swaps. WHat’s the same between AU and NZ? Rugby, tourism, cricket, debt. Otherwise SFA in economic terms. It is all about bailing out the treasonous racketeering AU executive and financial… Read more »
Ross
Guest

André, C. (2010), “A Bird’s Eye View of OECD Housing
Markets”,

http://www.frbatlanta.org/documents/news/conferences/12fmc/12fmc_andre.pdf

Lachlan
Guest

Hi Ross. Good link at a glance. Might cosy up with a coffee or ten tonight.

X
Guest
>> So how much would the person with a discount rate of 5% be willing to pay? We won’t get into the math, but this bond price calculator says $122.08. (It’s probably calculating a semi-annual coupon payment, but let’s ignore that.) Er … what? I think you should get into the math if you think a 1% yield discounted at 5% is $122.08. I used the same bond calculator (in your link) and got $83.34, which is correct assuming a 1Y coupon period. Unless you meant the coupon is $10 per year (10%)? Two points of concern. (1) Nobody proof-read… Read more »
wpDiscuz
Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au