After six years in a rising market, the question everyone is asking is “Is the market currently overvalued?”. To answer this question, we need to ask ourselves a different question: What makes an attractive investment?

Our basic investment choices are shares, property, company bonds, or of course government bonds (which are called “Gilts” in the UK and “Treasuries” in the US).

Bonds are a loan to a company or government whilst shares are partial share ownership of a company. We have a choice of which of these to invest at any time, and must select the best return for the least amount of risk.

Looking at an example, which of these investments is more sensible? A house that would return 25% in rental income after all fees, or a company bond that returns 4%? Most would choose the house as the return is much better and the house is always yours to keep. The two factors we look at are the return (or yield) and the risk. In the example above there is a chance that the company could get into trouble and fail to pay back anything.

Let’s look at the example again, but with different figures and some additional information.

This time, the house returns 4% after all costs while the company bond returns 20%. The company is the National Grid and we know that the company has very little debt compared to its income. Now which one would you choose? The yield is much greater with the National Grid bond but the risk is harder to quantify than with the house rentals. However, as the return is so much higher, the bond looks much more attractive.

Not all bonds are created equal

For the third example, let’s compare a sterling company loan to a loan to the UK government bond where both yields are 4%. As the yields are the same, the only factor we assess is the risk. If the company goes bust then we lose our money. But what if the UK government runs out of money? As they control the currency they simply print more and will always pay us back, but you may have to wait to the maturity of the loan. So a loan to a government in its own currency is the safest investment in terms of getting the full loan amount (principle) repaid.

When looking at any investment we have to compare the return from government bonds (the “risk free rate of return”) and demand a higher return for more risk. The extra return is called the “risk premium”.

What is the risk-free rate of return?

The standard measure of the risk-free rate of return is the 10 year US government bond (called the 10 Year Treasury Rate) because the timescale is medium term and we know the government will always pay back in its own currency.

Here are yields of the 10 year US treasury bond from 1962 to today (the grey bars show the US recessions):

So the risk-free rate of return is currently historically low at 2.43%. In 2000 it reached over 6% and in 1983 over 14%. How things have changed!

As the risk-free rate of return changes, so does the attractiveness of other investments.

When the risk-free rate of return is high, other investments are worth less, as you would choose 9% Treasuries over 10% shares. When the risk-free rate of return is low, other investments are worth more, as you would choose 8% shares over 2% Treasuries.

So, for example, you have the opportunity to invest in a 10 year company bond which pays 3% whilst the 10 Year Treasury pays 2.5%. Is it worth investing in the company bond? You earn an additional 0.5% for taking the extra risk that the company may go bankrupt. I and many others would not make that investment.

When looking at any investment we have to compare the risk-free rate of return and demand a higher return for the increased risk from assets that are not government bonds.

Let’s look at our current options in an environment where the risk-free rate of return is 2.48%. We do this by comparing the earning yield of other assets. The table below shows the current earnings yield by asset class.

Currently US Shares immediately return 2.68% more than the the 10 Year Treasury, which makes them a better buy. This is in stark contrast to 2000 when 10 Year Treasuries returned 14% and US Shares 4% — clearly, back then, Treasuries were a better buy.

To answer our question “Is the market currently overvalued?” I believe the US stock market is reasonably valued given the historic low interest rate, although it is definitely not cheap.

But are government bonds safe in the short term?

Government bonds are risk-free with one assumption: that you hold them until their maturity date, i.e. if you hold a 20 Year Treasury from date of purchase for 20 years, then you are guaranteed to get your money back. But looking short-term though, these government bonds are currently very risky. As Warren Buffett recently stated, “If I had an easy way, and a non-risk way, of shorting a whole lot of 20- or 30-year bonds, I’d do it.” I will explain why.

Currently the yield on the 20 Year Treasury is 2.92%. The table below shows what happens to the value of the bond when interest rates rise.

If interest rates were to rise after your purchase, the value of your bond would fall because investors would not buy new issue bonds with a coupon as low as yours. In this case, your bond would be worth less than $100 to reflect this. As rates are currently very low, any small rise is bad news for bond prices.

Of course, you would get the full $100 back in 20 years time, but if in one year rates rise by 1% we are 28% down in market value — plus we can’t reinvest that money elsewhere as opportunities arise.

Hence, long term, low interest bonds are risky. Confusingly these bonds are labelled “risk-free” but we see with current low interest rates that risk prevails in long dated government bonds. Needless to say, I won’t be buying any in a hurry.

Disclaimer: The above does not constitute investment advice. The author has not invested in the companies mentioned at the time of writing but may invest in them at some point in the future.

Tim O'Shea
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Tim O'Shea

Fund Manager with 15 years' experience as a successful business owner-manager. Passionate about helping people benefit from the power of long-term investing.
Tim O'Shea
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