C.R.E.A.M.
Vol #32- April 2, 2021
Last week we talked about how plain vanilla is both the best ice cream and the best options strategy. This week it’s going to be about a different kind of C.R.E.A.M - and not exactly the kind popularized by the Wu-Tang Clan.
The Staten Island lyrical masters described how growing up “Cash Rules Everything Around Me” in the drug hustle. These days, the “C” is probably better replaced by Credit.
No matter who you are or what you’re doing, credit is everywhere, and it’s hard to understand. If basis points make your eyes gloss over today, they’ll make your wallets bleed tomorrow.
Interest rates seem insignificant in their magnitude. How much could a fraction of a percentage point really matter? Where does that number even come from?
James Carville famously told Bill Clinton that “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a . 400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
The bond market is the interest rate market. When bonds go up in price, interest rates fall. Bonds have a fixed coupon, and if demand for the bond causes its price to rise, the corresponding coupon will represent a lower yield. Buying a $100 bond for a $5 a year coupon is a 5% interest rate, paying $125 for that same coupon is a 4% interest rate.
Interest rates are an opportunity cost. When you borrow money with a mortgage to buy a house, you’re trading consumption today for payments over the next 30 years. A 5% rate means you’re paying back 93% more than you borrowed. A 4% rate means 71% more. (Before you jump at refinancing, make sure to take into account the cost of originating a new loan - it has a big impact on your expected savings.)
That same effect is in play at large with some of the recent market choppiness. Many tech companies have been jerked around as bond yields move. When the cost of borrowing jumps for companies fueled by debt, their future valuations whipsaw.
The power of interest rates is not their nominal magnitude, but how that credit compounds over time. As we see with the mortgage example, a relatively small difference can mean real dollars over time.
Fortunately compounding works both ways. When you’re earning yield, reinvesting dividends, and moving income into savings and investments, the treadmill starts spinning in your favor. The goal of every investor should be to get the wheel spinning in their favor.
There are good reasons and opportunities to borrow money and pay interest. Owning a home can be rewarding and sometimes even a profitable investment. Borrowing to start a business lets entrepreneurs fund their dreams. But credit for consumption starts turning the gears the wrong way.
What’s important in a system that is awash with credit, is to know what you’re getting into. Compound interest grows geometrically. Minor differences in loan payments can have major effects down the road. Increasing your mortgage payment by 10% to pay down principal, can cut your borrowing time (and cost) nearly in half.
I’m a big fan of James Clear, and his work on the power of habits. He proposes the idea of Continuous Improvement, and gives the simple motivational notion of improving 1% every day. At the end of the year you end up 37x “better” (1.01^365).
You don’t even have to be that good. Bitcoin has only grown 21 basis points a day (21% of 1%) over the last 8 years. I certainly wish I could buy it now for $134 instead of $59,373.
Thanks for joining us,
Mark Phillips
Principal