The basic premise is that overpaying for earnings today leads to lower rates of return in the future. Of course, given the flood of liquidity from global Central Banks, the overvaluation of markets is of no surprise. While Central Bank interventions boost asset prices in the short-term, there is an inherently negative impact on economic growth in the long term. At maturity, the principal gets returned to the «lender» along with the final interest payment.
As opposed to an equity buyer taking on «investment risk,» a bond buyer is «loaning» money to another entity for a specific period.
Since the future return of any bond, on the date of purchase, is calculable to the 1/100th of a cent, a bond buyer will not pay a price that yields a negative return in the future.
Current benchmark interest rates = 5%A $1000 bond gets issued at 100.00 with a 5% coupon with a 12-month maturity.
Rates Are A Function Of The Economy
The relationship, shown below, should not be surprising given that, as stated above, the «rate» charged for lending money must account for economic growth and inflation. Let me clean this up by combining inflation, wages, and economic growth into a single composite for comparison purposes to the level of the 10-year Treasury rate. Otherwise, capital is damaged due to inflation and lost opportunity costs. As shown, the correlation between rates and the economic composite suggests that current expectations of sustained economic expansion and rising inflation are overly optimistic.
At current rates, economic growth will likely very quickly return to sub-2% growth by 2022.
Source: Lance Roberts | Real Investment Advice