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Cost of capital
Finance’s most important yet misunderstood prices are interest rates. Here’s what happened to the cost of money in the past fortnight.

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Stock prices fell again last fortnight. The S&P 500, an index of big American companies, dropped 1.4% to 3,824. The market has bounced back from its October lows but is still down 20% in the past year. I value the S&P 500 at 3,922, which suggests it is fairly valued.


The companies in the index earned $1.8trn after tax in the past year. They paid out $506bn in dividends and $1,030bn in buybacks and issued $71bn worth of equity.

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Government bond prices fell. Yields, which move the opposite way to prices, rose even though inflation expectations fell. The yield on a ten-year US Treasury bond, a critical variable analysts use to value financial assets, climbed 11 basis points (bp) to 3.8%. Investors expect inflation to average 2.2% over the next decade, down 5bp from the rate they expected last fortnight.

Hence, the real interest rate, the difference between yields and expected inflation, rose 16bp to 1.6%. These inflation-adjusted rates rose 2.5 percentage points in the past year.

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Corporate bond prices also fell. Credit spreads, the extra return creditors demand to lend to businesses instead of the government, fell by 1bp to 1.7%. The spread on these BBB-rated bonds is up 54bp in the past year.

The cost of debt, the annual return lenders expect when lending to these companies, leapt 10bp to 5.5%. Refinancing costs have almost doubled, up 2.7 percentage points, in the past year. Lenders now charge firms about the highest interest rates since 2009.

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The equity risk premium (ERP), the extra return investors demand to buy stocks instead of risk-free bonds, rose 8bp to 5.2%. It’s now 45bp higher than where it was a year ago. In addition, the cost of equity, the total annual return these investors expect, rose 19bp to 9%, 2.6 percentage points higher than last year. These expected returns are also roughly in line with the long-term average.

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