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The Federal Reserve's resolute commitment to maintain lower interest rates appears to be unshakeable. Rates on 10 year Treasuries hover around 2 percent and even 30 year Treasuries yield less than 3 percent. I have recently written a piece entitle "Dow 47,150" explaining how the application of the "Fed Model" to the current market would produce nearly a quadrupling of current stock prices. I am not a slavish follower of metrics and I do not think that 47,150 is on the horizon, but I do think it is important to analyze some of the ways that lower interest rates may work their way into equity valuations.

At the outset, it is important for an investor to understand how and to what extent interest rates affect the market for equities. Some analysts use market valuation metrics which totally ignore interest rates - two examples are the Tobin Q and the price to ten year trailing earnings ratios, both of which produce the same results when short term treasuries yield 15% as they produce when short term treasuries yield 0%. An investor has to decide whether this is reasonable and, if not, exactly how and to what extent interest rates modify his analysis of the market.

I should reveal my bias. I believe that sustained short term interest rates do affect the valuation of the equity market. I believe the effect is strongest when risk spreads are at average or below average levels. I also believe that the effect on the market is uneven (some sectors are affected more than others - e.g., in 2010, utilities were the strongest performing sector). I should warn readers that many very experienced and prestigious analysts disagree with me; each investor has to look at this matter for himself. I will say that, at this time, it is the single most important consideration in deciding whether to be long, short, or out of the market.

As a general matter, a low interest rate environment tends to increase the value of debt instruments. A fixed rate debt instrument must be repriced to bring its yield to maturity into line with prevailing interest rates and as interest rates decline, the value of the fixed rate bond or debt instrument generally increases. Thus, all other things being equal, a pool of fixed rate debt instruments will increase in value as prevailing market interest rates decline.

Of course, all other things are never equal. The most important consideration is default risk. If the pool of debt instruments includes one or more instruments presenting material default risk, then the impact of the default risk may swamp interest rate considerations and hold down the value of the pool. Default risk is, of course, specific to particular debt instruments, but pools of debt instruments can be affected by the general perception of risk and the interest rate premium the market demands for various levels of risk at various times. These market conditions are reflected in "spreads" - the degree to which bonds of various risk levels are priced to produce yields in excess of the yields on treasuries of the same duration.

A year ago, spreads were beginning to be quite low. They shot up over the Summer and are still considerably higher than they were at the bottom. A good way to check on spreads is to look at LIBOR and compare it with treasury interest rates of a similar duration or to look at the Confidence Index posted in Barron's (the ratio between yields on investment grade and intermediate corporate bonds).

I won't go into "call" provisions or special problems associated with floating rate securities in detail because this is not an article on the bond market. However, as a general matter, a pool of debt instruments including at least some fixed rate debt instruments will increase in value as prevailing market interest rates decline.

Certain equities are structured to include a pool of debt instruments as their sole or primary asset. Generally, some leverage is employed and the corporation makes profits based on the interest rate earned on the debt instruments it owns minus the interest rate charged on the debt it owes. At this point, my description would appear to include banks and, as a general matter, when banks can pay out very low interest rates on deposits, they often can earn attractive profits. We will discuss banks in more detail later in this series. In this sector, I will discuss mortgage real estate investment trusts (MREITs) and business development companies (BDCs).

MREITs invest in mortgages secured by real estate; some MREITs -agency mortgage REITs like Annaly Capital (NLY) and Hatteras Financial (HTS) - hold solely mortgage instruments directly or indirectly guaranteed by a federal government agency, others hold non-agency residential mortgages, still others hold commercial property mortgages -like RAIT FinancialRAS) and Starwood Financial (STWD) - and finally some are "hybrids" - like Invesco Mortgage Capital (IVR) - holding a mix of different type mortgages. Most residential mortgages can be repaid without penalty so that a period of lower interest rates can lead to waves of prepayments and the replacement of high yield mortgages with lower yielding instruments. Commercial mortgage REITs still face considerable default risk. Each company faces specific risks of its own, but I believe that there is still considerable potential for a client to earn a high single digit or a low double digit return (which is very attractive at these interest rates) in this sector with a combination of price action and dividends with careful timing and stock selection.

Business development companies (BDCs) generally loan money to small or medium size business although many BDCs hold a large amount of equity in the companies they invest in. The business loan market has fluctuated as there have been periods in which the banks, which also participate in this market, were very risk averse. It is possible to analyze the balance sheets of BDCs and determine the asset mix. In some cases, an investor can buy the stock at such a discount to net asset or book value that he is, in essence, buying a book of loans at a significant discount to its fair value. BDCs that have presented opportunities of this type in the past year are American Capital (ACAS), Kohlberg Capital (KCAP), MCG Captial (MCGC) and Saratoga Investment (SAR). At the bottom of the market this past summer, other BDCs were selling at significant discounts. As defaults have stabilized and as investors gradually become more comfortable with the loan analysis leading to the fair value calculations in BDC quarterly financials, BDC market caps should close up on book value. Because these stocks - like mortgage REITs - tend to pay high dividends, an investor can earn an attractive total return in this sector even if there is not a great deal of price appreciation.

All sorts of things can affect the performance of an individual company in one of these sectors. However, an investor buying a mix of these equities as part of an income oriented portfolio will probably do considerably better than he will with most fixed income securities - especially if he waits to buy when prices are well below book value for BDCs. As more and more investors get comfortable with these sectors, they will be able to raise money in secondary offerings (there were quite a few in the first half of 2011) and thus provide more lending to the small business and real estate sectors of the economy. Thus, in a very indirect way and at the end of a long, winding road, low interest rates can begin to increase the access of small businesses and real estate companies to the credit markets.

Continue to Part 2: Stock Repurchases >>

Source: The Interest Rate Tailwind And The Stock Market: Buying Debt In The Equity Market