Viewpoint: The Term Structure of Interest Rates and Timberland Discount Rates (Part 1)

22nd June 2019

Margules Groome Consulting (Brian Johnson and Rudolf Rensburg)
Forest Research Group (Dr Jack Lutz)


Margules Groome and Forest Research Group has prepared this Viewpoint report based on information available to it at the time of its preparation and has no duty to update this material. Nothing in this Viewpoint is or shall be relied upon as a promise or representation of future events or results.

Margules Groome and Forest Research Group expressly disclaims any and all liability arising out of or relating to the use of this Viewpoint report.

The frequency and amplitude of media coverage pointing towards headwinds that the global economy may face over the next ~18 months is on the increase. Observations include:

  • Risk associated with the USA being able to service its USD22 trillion debt bubble (88.3% of GDP) in the medium to longer term given rising interest rates and declining corporate tax revenues, the latter being at a 75-year low due to tax cuts
  • Increasing risk for a hard landing for the Chinese economy. Risk stems from predominantly two sources: (i) non-performing loans and bad debts in the shadow banking sector, being non-bank financial institutions operating in less regulated wholesale markets; (ii) over capacity in many sectors of the economy (industrial, housing, offices and other infrastructure). Analysts argue that this is in part the result of China’s planned economy and that over investment was also a feature of the South East Asian economies in 1990s which ended in the 1997-2002 Asian financial crises
  • Overvalued residential property bubbles with Australia, Canada, China, UK and Sweden leading the way
  • Brexit and weak fundamentals in the European economies, Italy in recession, concerns about Deutsche Bank
  • US and China trade conflict and geo-political tensions, most notably in the South China sea
  • Increasing environmental risk with the World Economic Forum in Feb 2019 indicating that the highest likelihood, highest impact risks are shifting from economic to environmental.

Many stock market analysts argue that a major stock market correction is likely to occur within the next 18 months based on historic market patterns, combined with the fact that the market is currently overvalued.

This paper examines the term structure of interest rates and what we may learn from historic trends. It further examines what (if any) relationships may exist between changes in the term structure of interest rates and the performance of timberland returns as measured by the National Council of Real Estate Investment Fiduciaries (NCREIF) Index in the USA.

Figure 1 shows the monthly development of US Treasury yields from 1982 to February 2019 in the secondary bond market. It also shows the 1990/1991, 2000/02 and 2007/09 recession periods that the US economy experienced. Green and red lines indicate historic points of stock market peaks and troughs.

Figure 1:
United State Treasury Yields (Nominal)

Figure 1 is instructive and reveals the following:

  1. Interest rates have been trending downwards over the past 37 years (while global debt levels increased)
  2. Shorter-term (3 months to 1 year) interest rates fell by about 5 percentage points in each of the last two recessions
  3. Longer term interest rates (10 years and 30 years) fell by about 3%
  4. Shorter-term and longer-term interest rates crossed (the yield curve inverted) prior to the last three recessions.

Figure 2 examines the term structure of the yield curve as at February 2019 and for each of the preceding 3 years.

Figure 2:
Term Structure of Interest Rates (Nominal)

We observe that the yield curve has been flattening significantly over the past 12 months, currently with only 69 basis points difference between 3 month and 30-year term yields. History suggests that a flattening of the curve typically points to an economic slowdown.

Figure 3 depicts 12-month 10-year and 30-year treasury yields in real terms. It also depicts NCREIF timberland EBITDDA returns.

Figure 3:
Inflation Adjusted Treasury Yields and EBITDDA Timberland Returns

A closer examination of Figure 3 suggests:

  1. Long-term (30-year) yields increase post-recession, in line with broader economic recovery and as the structure of the yield curve normalizes
  2. Based on evidence from the two most recent recessions, timberland discount rates tend to increase with recessions although there was a marked delay and only a relatively modest increase during the 2007 – 2009 recession.

There appears to be a reasonable correlation (0.84) between NCREIF Timberland EBITDDA returns and 30-year treasury yields. There appears to be a weaker correlation (0.44) between Total Timberland returns and longer-term treasury yields. Total Timberland returns include capital returns in addition to EBITDDA returns. The correlation between EBITDDA returns and shorter-term interest rate movements (12 months) is not as strong (0.75) as the correlation with longer-term rates. Correlation between total returns and shorter-term rates are weaker (0.45).

A question of interest is the likely movement of timberland discount rates in a possible future recession scenario. If the historic declines (3-5%) in interest rates were to repeat, US yields will enter negative territory for the first time in history.

In several European countries, bonds have been trading at negative nominal yields for some years. Investors typically accept negative bond yields in the absence of inflation or during deflationary times when purchase power will not be eroded.  During periods of deflation when prices overall are falling, an investment may still come out ahead even if you earn 0% or less.

Analysts argue that negative bond yields could potentially be correctly forecasting a sharp economic slowdown, which, consequently, could lead to an increase in defaults (both corporate and sovereign) in the future. Deflation has a similar effect. Investing now and receiving less nominal money in the future can be profitable if the price of assets has fallen sufficiently.

How favourable will investors consider timberland investment in a deflationary economic environment, considering the particular liquidity characteristics of timberland investment and its traditional tendency to lag other market indicators?

Part 2 of this Viewpoint report will investigate historic timberland discount rate developments in the US and Oceania markets over the same time period to understand what the historic relationships between interest rate changes, timberland discount rates and timberland investment returns may be.