Having an idea of what something is worth is clearly fundamental to managing investments. How though does one arrive at an acceptable price to exchange “cash at bank” that has a fixed value for an asset that has a price today but often a deeply uncertain value in the future? Is there any method in the madness of financial markets?

Fundamentally, any tradeable price is the price which clears the market by matching available supply with the prevailing demand. Open outcry markets which used to be a feature of the City but which, sadly, are now largely closed, literally put buyers and sellers, producers and consumers, in a ring until the market cleared at a price arrived at by shouting at each other. It was sight that was both hugely entertaining but entirely impenetrable to an outsider. Yet the global price of commodities like zinc, tin, silver, and aluminium were/are set in this way.

Go to any farmers’ market and you will see sheep, cows and bulls traded in the same way. Producers and consumers gather in a ring and an utterly incomprehensible auctioneer will match demand to supply. Not so long-ago stocks and financial futures were traded in a not dissimilar way, but those days have given way to the computerised SETS screen, matching bids and asks from inputs from trading desks across the City.

So, an auction process will prove effective as a price discovery mechanism but that still doesn’t answer the question of where you should pitch your opening bid or opening offer. That is where investors need a yardstick, and that yardstick is typically the yield on a high-quality Sovereign bond; in the UK, a gilt; in the US, a Treasury and in Germany, a Bund.

Why should this be so? Principally because any of the three bonds noted above provide an investor with a benchmark series of absolutely guaranteed returns with zero risk. These assets are backed by the respective taxpayers of their respective governments. Few people question the credit worthiness of the US or Germany. They also provide a model with which to appraise assets with competing cashflows and payoffs.

What would you pay for an asset that will give you £5 a year for ten years and your initial capital back, £100, at the end of the tenth year whilst prevailing variable interest rates were 5%? The answer is you would pay £100, you wouldn’t pay more because you would be foregoing a higher return on cash, but you would pay less (although an “efficient” market wouldn’t let you).

But, what would you pay for the same cashflow if interest rates fell to 4%, then 3% and then 2%? The answers are £108, £117, and £126. In the last few years gilts and other fixed interest investments have proved to be very valuable as the Bank of England has pushed interest rates to near zero and bond prices have risen inexorably.

Why is this important now? Well because higher inflation is likely to push interest rates higher and the process described above works in both directions.

An investment that paid £2 when prevailing interest rates were 2% would be worth £100. The same investment, if rates went to 3%, 4% and 5% would be worth, £91, £83, and £76. The key point is that whilst gilts are regarded as “risk-free” – (which they are if held to maturity, but 30 years is a long time to wait), record low interest rates have made them risky. The risk is not one of default; the risk comes from the interest rate cycle and the prospect that the era of ultra-low yields has ended. This is true of Bunds, Treasuries, BTPs and OATS and all the other flavours of international sovereign bonds.

These instruments and above all, the US Treasury, are fundamental to finance because they set a benchmark price for a series of future cashflows from 1 week to 50 years. Virtually everything is priced off these so-called “yield curves.”

So, if interest rates are rising, thereby depressing the value of fixed income assets (and assets which pay no income but rely on price appreciation for the investment return), what should investors do?

Consider that the present value (price) of a stream of £2 payments at a discount rate (d) of 2% is £100. That is what you would pay for that stream of fixed payments at a prevailing interest rate of 2%. But, if that £2 was not fixed but grew by 2% per annum; what would it be worth then? The answer is £120. If the growth rate of that stream of income was 5%, you would pay £157 to own it (at a prevailing interest rate of 2%).

What divides equity from fixed income is “g”, the growth rate of corporate earnings and thus the potential to pay higher dividends. If interest rates are rising because growth is normalising, then the “g” in the equation makes equity a much better investment than fixed income.

History shows that the patient investor is usually the one that is rewarded for accepting the volatility attached to investing in equities.