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the long view

Can your portfolio pass the 2-per-cent test?

Over the past few years, most of us have watched our net worth rocket as yields on bonds and savings accounts have dwindled, and bonds and stocks have soared. But few Main Street investors have paused to consider what would happen if interest rates start moving higher – even if it's only by a couple of percentage points.

A money manager recently walked me through a story that demonstrates the impact of a two-percentage-point rise in interest rates. It's an example that shows the large amount of risk that may be lurking in even apparently conservative investments and shows why the big profits of the past few years may be more vulnerable than you think.

Start by imagining an investor who owns a high-quality apartment building in Toronto that produces $100,000 in income after expenses have been paid. In today's market, the building is probably worth about $2.5-million.

Its multimillion-dollar value is based on the fact that apartment buildings are changing hands these days at around a 4-per-cent "cap rate," or investment yield. Investors are content with a 4-per-cent payoff from a real estate investment because 10-year government bonds are yielding under 2 per cent.

Sure, the apartment-building owner is taking on more risk and more hassles than a buyer of safe government bonds and needs to be compensated accordingly, but in today's market, a 4-per-cent return looks positively gaudy compared to paltry bond yields. As a result, a building that generates $100,000 in annual income is worth $2.5-million because that income represents a 4-per-cent yield on the cost of the building.

But what happens if the yields available on government bonds were to rise by a couple of percentage points to, say, 4 per cent? In that case, any potential buyer of the apartment building is going to want more than the 4 per cent they could earn from safe bonds. She would want to earn at least 6 per cent on her money to make the investment worthwhile.

Here's the problem: If investors start to demand a 6-per-cent return on their money, a property that produces $100,000 in annual income is not worth $2.5-million any more. It's worth less than $1.7-million.

There's nothing surprising about this plunge in value. If an investor can reasonably demand a 6-per-cent yield from investments of similar risk, you have to invest only about $1.7-million to create an annual income of $100,000, so that's fair value for the apartment building.

Still, the net effect will come as a shock to many people. A mere two-percentage-point increase in interest rates wipes out a third of the value of the property.

The effect is amplified if we assume our hypothetical investor has borrowed to buy the building. If she owes, say, $1.2-million, her equity in the building is worth $1.3-million when it's valued at $2.5-million. But her equity slides to less than $500,000 if the building's value slumps to under $1.7-million. The two-percentage-point bump in interest rates wipes out nearly two thirds of her wealth.

To be sure, this example is deliberately dramatic, but it represents the forces that will come into play when interest rates do start rising. Once government bonds begin providing more appealing alternatives for investors, people will start asking for higher yields not just from real estate, but from corporate bonds and from stocks as well.

If government bonds were to revert to levels more in keeping with their historical average, yields would more than double and investors would reprice stocks accordingly. Rather than trading at more than 18 times earnings, the S&P 500 would probably change hands for under 15 times, as it has done for most of its history. Everything else being equal, that would imply a fall of roughly 20 per cent in stock prices.

Some people see little chance of rates rising any time soon. Given that the Government of Canada has recently been able to sell 50-year bonds for yields under 2.6 per cent, many buyers appear to be counting on low interest rates for many, many years to come.

But cautious investors should ponder the recovery that appears to be unfolding in the United States and ask themselves what would happen to their portfolio if interest rates climb back to more normal levels.

In such a scenario, leveraged portfolios and dividend stocks would be two areas of particular pain since both have been prime beneficiaries of today's low rates. Cash and short-term bonds would be the obvious refuges. One way or the other, rising rates – when and if they come – will reshape the market.