The discount rate, a combination of risk free return and a premium (reward for taking risk on capital), is central to all fundamental asset valuation methodologies. This measure of cost of capital has been under pressure since major global central bankers flooded financial systems with cheap money. For example, the US 10 year yield has fallen from an average of 2.76% in 2011 to 2.01% currently. Similarly, our local 10 year yield in NZD declined from 4.91% to 3.84%. The tide of lower risk free rates, and by extension discount rates, lifted all boats in 2012 as returns on bonds and equities firmed.

However, there are signs that this declining trend in bond yields has abated. Most major developed economies, with the exception of Japan and troubled European states, have seen their sovereign yields rebound significantly to 6 month highs.

This has yet to cause an adverse reaction in global equity markets as investors are inclined to view this as an indication of fund flows away from fixed income to equity markets. This argument should hold as long as bond yields sneak up gradually under the guise of improving macro conditions. Also, the second element of the discount rate, the equity risk premium, could narrow on more rosy investor sentiment. But investors should be mindful that a sharp upward move in bond yields could eventually hurt equities too.

Felix Fok

Senior Analyst