A&W Capital CAPITAL HOLDING COMPANY
Why are we interested in Commonwealth Bond yields?
Below is an extract from the September 2019 letter to the shareholders. It defines why we are interested in commonwealth bond rates and what a yield curve inversion means to us.
As per previous letters: - “The yield on commonwealth 10-year bonds is important to us. It’s used as an input to our calculations for the intrinsic value of a company. It's value is as a measure of the risk free rate of an economy. That is what interest rate can be obtained on capital relatively risk free. The 10-year yield on commonwealth bonds is the proxy for that rate. Small movements have little bearing on calculations but large movements in yield do affect a company’s intrinsic value that we are calculating.”
We are currently using a risk free rate of 0.95% to match the 10-year bond yield. For those paying attention you will notice a significant fall in yield since January’s letter. Bond price and yield have an inverse relationship. As demand drives bond prices higher, the yield on those bonds goes down. So bond participants are buying into 10 year bonds driving the price up and yields down. This price information tells us that bond participants expect price volatility to be high in the near term and have formed the view that money will be less volatile in long dated bonds. In fact this reduction in yield has formed an inverse curve when comparing the 10 and 2 year US Treasury bonds in what the press have been calling a ‘yield curve inversion’ and precursor to a falling economy.
Can these bond participants predict a falling economy? Whether they can or not doesn’t change our business. We don’t time the market, rather we price businesses and take advantage of the price opportunities when they arise which they do periodically. Refer to Figure 1 for the 10-year Australian Government Bond Yield history.
As per previous letters: - “The yield on commonwealth 10-year bonds is important to us. It’s used as an input to our calculations for the intrinsic value of a company. It's value is as a measure of the risk free rate of an economy. That is what interest rate can be obtained on capital relatively risk free. The 10-year yield on commonwealth bonds is the proxy for that rate. Small movements have little bearing on calculations but large movements in yield do affect a company’s intrinsic value that we are calculating.”
We are currently using a risk free rate of 0.95% to match the 10-year bond yield. For those paying attention you will notice a significant fall in yield since January’s letter. Bond price and yield have an inverse relationship. As demand drives bond prices higher, the yield on those bonds goes down. So bond participants are buying into 10 year bonds driving the price up and yields down. This price information tells us that bond participants expect price volatility to be high in the near term and have formed the view that money will be less volatile in long dated bonds. In fact this reduction in yield has formed an inverse curve when comparing the 10 and 2 year US Treasury bonds in what the press have been calling a ‘yield curve inversion’ and precursor to a falling economy.
Can these bond participants predict a falling economy? Whether they can or not doesn’t change our business. We don’t time the market, rather we price businesses and take advantage of the price opportunities when they arise which they do periodically. Refer to Figure 1 for the 10-year Australian Government Bond Yield history.
