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Hello and welcome you are 
listening to Patrick Boyle on 

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Finance, a podcast exploring 
ideas from quantitative finance,

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examining events occurring in 
markets right now and financial 

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history to see what lessons can 
be taken away, including 

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interviews with some of the most
interesting people in the world 

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of finance. 
To learn more about the podcast,

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visit on finance.org. 
The 10 year U.S. 

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Treasury yield closed above 4.9%
yesterday, its highest level 

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since July 2007. 
While that might not seem like a

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big deal to most investors, 4.9%
is not really a surprisingly 

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high interest rate in the 
greater scheme of things. 

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What it means is that bond 
investors in longer dated 

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Treasuries have lost around half
of their money since early 2020.

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A-Team of analysts at Bank of 
America are calling this the 

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greatest bond bear market of all
time, The Long Term Treasury ETF

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which invests in U.S. government
debt maturing in at least 10 

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years. 
Is down 8 1/2% over the last 

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month and it's half since its 
high in March 2020. 

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That would be considered a 
terrible loss in the stock 

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market, which is at least 
expected to be volatile. 

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It's a devastating loss for bond
investors, who are typically 

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seen as being risk averse 
investors seeking stable returns

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and income. 
The current losses in long 

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maturity debt more than double 
the losses that occurred in 

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1981, when Paul Volcker's 
campaign to end persistent 

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inflation drove 10 year Treasury
yields to almost 16%. 

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Since 1945, there have only been
3 stock market drawdowns of 40% 

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or more, the most recent two 
being the bursting ofthe.com 

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bubble and the financial crisis 
of 2000 and seven 2008. 

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So what's happened in the bond 
market is one of the ugliest 

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losses in modern financial 
history. 

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The financial press is 
describing these as paper 

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losses, as if you hold on to the
bonds you bought at near 0 

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interest rates. 
You do eventually get the money 

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that you put in back when the 
bonds mature. 

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You locked it up at close to 0% 
for 10 years or more, and that's

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exactly what you get. 
No return over a long period of 

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time. 
That doesn't look great in this 

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inflationary environment, 
however. 

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The fact that investors can buy 
a bond that yields 4.9% today is

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the reason that the bonds bought
in 2020 when interest rates were

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near 0 have to be sold at a big 
discount today if you want out 

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of them. 
It's hard to believe that the 

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federal funds rate was near 0 as
recently as the first quarter of

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2022. 
The Fed was still buying 

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billions of dollars of bonds 
every month to stimulate the 

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economy back then as well. 
All of this despite 40 year 

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highs in various measures of US 
inflation. 

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Once the Fed began hiking rates,
it moved forcefully. 

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But the rate that the Federal 
Reserve controls is a short term

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interest rate when investors 
believe that inflation would be 

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brought quickly under control. 
Longer dated interest rates 

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stayed low on the expectation 
that as soon as inflation was 

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defeated that the Fed would 
begin cutting rates once again. 

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Investors now believe that rates
will stay higher for longer. 

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So if the Fed only sets short 
term interest rates, who sets 

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longer term rates? 
Well, academics argue that 

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yields on long dated bonds are 
determined by the anticipated 

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path of short term interest 
rates. 

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The idea is that investors would
buy a series of one year bonds 

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rather than a 10 year bond if 
they believe that doing so would

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produce a better return. 
If they're unwilling to buy 

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longer dated bonds, bond issuers
will need to offer a higher 

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interest rate until buyers 
emerge. 

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This supply demand dynamic means
that investors and borrowers 

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interest rate expectations 
determine long term interest 

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rates. 
These rates settle at levels 

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where investors are indifferent 
between buying a series of short

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term bonds or just buying the 
long term bond. 

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Other factors also influence 
yields. 

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Investors typically demand some 
extra yield to compensate them 

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for taking the risk of tying 
their money up for a long time, 

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due to the possibility that 
rates could end up higher than 

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they expect today. 
Additionally, yields can be 

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influenced by the supply of 
government bonds. 

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If the government wants to 
borrow a lot this high demand 

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for investors, capital can push 
yields up. 

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Demand will matter, too. 
Foreign central banks have grown

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their reserves a lot over the 
last 20 years. 

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If they're expected to stop 
growing their reserves, there 

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would be less demand for bonds 
and interest rates would rise. 

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Quantitative tightening by the 
Federal Reserve, who have 

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stopped buying bonds and are 
allowing their existing 

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portfolio to mature, is another 
factor reducing demand for 

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bonds. 
Sometimes investors will accept 

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a lower yield on longer dated 
bonds, known as a negative term 

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premium, because they expect an 
economic slowdown which will 

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then lead to interest rate cuts.
And those new lower rates will 

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make the bonds that they bought 
back when interest rates were 

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higher more valuable. 
Now that borrowing costs have 

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reached their highest levels in 
over 15 years, let's look at who

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benefits and who feels the pain 
at these new, higher interest 

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rates. 
Treasury yields Dr. the interest

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rate on everything from 
mortgages to corporate debt. 

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And for this reason, the new 
higher rates that we're seeing 

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have become a source of anxiety 
for investors. 

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So far, their worries have 
mostly been unfounded, as the 

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economy has shown little sign of
buckling under the higher 

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borrowing costs. 
Higher bond yields can also have

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the effect of making riskier 
assets like stocks seem less 

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attractive, as investors can now
earn a reasonable return 

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investing in bonds. 
A few years ago, people used to 

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argue that there was no 
alternative to investing in the 

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stock market. 
Now there is. 

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Inflation today stands well 
below its peak last year of over

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9%, but it stubbornly remains 
more than a percentage point 

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higher than the Federal 
Reserve's target rate. 

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The move in longer dated bond 
yields is driven largely by an 

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acknowledgement among investors 
that inflation may be more 

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persistent than they had 
initially expected, which could 

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keep interest rates higher for 
longer. 

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Worries over large government 
spending plans and high 

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borrowing requirements in the 
United States have pushed yields

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higher, too. 
Investors are concerned about 

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government spending as while 
rates have been at 5% or much 

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higher in the past, they've 
never been at that level, with 

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$33 trillion in debt 
outstanding. 

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So first up, how will the 
consumer be affected by higher 

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interest rates? 
Well, mortgage rates today stand

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at their highest level in more 
than 20 years. 

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The average interest rate on 
credit cards tops anything on 

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record at the Federal Reserve. 
Car loans have returned to 2008 

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levels, too. 
Each percentage point increase 

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in a mortgage rate can add 
thousands or 10s of thousands of

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dollars in additional interest 
rate expense to borrowers, 

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depending on the size of the 
mortgage. 

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This can be expected to weigh on
real estate prices, as the cash 

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flow required to buy a house at 
a given price point today is 

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considerably higher than it was 
a year or two ago. 

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A lot of American homeowners who
want to move house have decided 

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to stay put, as moving house 
usually involves paying off your

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mortgage and then borrowing 
again at the new, higher 

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interest rate. 
Doing this would involve either 

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higher monthly mortgage bills 
for an equivalently priced 

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house, or buying a cheaper home 
than the one that you're 

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selling. 
For this reason, a lot of 

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homeowners are deciding to spend
money on home improvements 

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rather than moving house. 
This morning we saw that US 

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existing home sales have fallen 
to their lowest level since 

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2010. 
The impact of higher bond yields

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on the consumer is mixed, as 
those who borrow money will feel

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a squeeze, while individuals 
with savings will benefit from 

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earning higher returns on their 
cash in money market accounts or

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the bonds they can invest in. 
Different businesses have 

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different interest rate 
sensitivity to financial firms 

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like banks. 
Insurance companies, brokerage 

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firms and money managers 
historically have done well when

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interest rates move higher. 
Banks, for example, get to 

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collect higher interest rates 
from borrowers while keeping 

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deposit rates low. 
This time around, higher rates 

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haven't worked as well for banks
as they did in the past, as we 

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saw in the regional banking 
crisis earlier this year, where 

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a number of banks had locked up 
money at low interest rates and 

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their depositors began pulling 
their deposits for a variety of 

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reasons. 
Third quarter profits at Bank of

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America that came out a few days
ago beat expectations, but the 

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bank's growth lagged to other 
large banks. 

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As Bank of America still has 
hundreds of billions of dollars 

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of low yielding bonds that it 
bought during the pandemic 

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losses on American banks, bond 
portfolios have drawn a lot of 

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attention this year. 
These mark to market losses are 

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now close to $400 billion. 
An all time high and 10% above 

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the peak at the start of this 
year that caused the collapse of

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Silicon Valley Bank. 
Most banks, and in particular 

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the largest ones, won't have to 
sell any of these bonds. 

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And so we'll never realize these
losses, but because they locked 

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money up at low rate, they're 
now missing out on the higher 

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rates they could have earned, 
which will be a drag on 

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profitability. 
Life insurance companies are big

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holders of bonds, too, which 
they use to back liabilities 

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like pension obligations. 
Like banks, most of these firms 

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can often hold their existing 
bonds to maturity, 

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underperforming because they 
locked up their money at low 

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rates but not being forced to 
sell. 

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Their worry is that a rapid rise
in rates might encourage their 

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customers to cash in long term 
products, forcing them to sell 

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bonds and other matching assets 
at a loss. 

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In general, higher bond yields 
are good news for defined 

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benefit pension funds because it
improves their funding position.

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US defined benefit pension funds
have about 3 1/2 trillion 

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dollars in assets on their 
management. 

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Their funded ratios are above 
100% sustainably for the first 

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time since the financial crisis,
and their fixed income 

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allocations have been rising for
the past decade or more. 

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These funds were really 
struggling back in 2011 or 2012 

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when they're funded ratios were 
well under 100% and their fixed 

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income asset allocation was 
around 35%. 

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These fixed income allocations 
are now over 50% according to 

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research from JP Morgan, and 
could quite likely grow. 

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The speed of this interest rate 
increase means that many of the 

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portfolio managers are likely 
taking their time to add 

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duration to their portfolios and
are waiting to see volatility 

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decline before making a bigger 
commitment. 

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Corporate debt markets have come
under a lot of pressure as 

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government bond yields have been
rising too. 

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The average yield on US junk 
bonds has been above 9% since 

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the end of September. 
Credit spreads, A barometer of 

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default risk, have been rising 
too. 

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The moves have been most extreme
at the riskiest end of the 

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credit spectrum. 
There are a lot of companies who

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wisely took advantage of ultra 
low interest rates during the 

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pandemic to borrow cheaply and 
push out maturities so that they

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don't have to refinance for 
quite a while. 

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However, a lot of debt will 
start coming due in the next two

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to three years. 
Junk rated loans, which have 

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floating interest rates, have 
already been feeling the effects

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of higher interest rates. 
Rising yields put the most 

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pressure on the most levered 
companies and you might start to

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see a higher default rate from 
companies that have managed to 

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scrape by, mostly due to the 
cheap financing they were able 

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to get in the past, which is not
available today. 

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For the past 20 years, private 
equity has been a relatively 

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simple business of buying a 
company using cheap debt and 

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long term capital from 
investors. 

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Sustained high interest rates 
are bad news for that business 

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model on a number of fronts. 
Leveraged buyouts obviously rely

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on leverage it in the name and 
as the cost of that leverage 

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rises, the deals that can be 
done are a lot less attractive. 

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The slowdown in the deal cycle 
has made it more difficult for 

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PE firms to sell assets and 
return money to their investors.

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The ability of the companies 
that they've invested in to 

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service their debt loads is also
becoming more strained right 

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now. 
Researchers at Carlyle Group 

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have warned that the rising cost
of debt has dramatically lowered

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interest coverage ratios across 
the private equity universe, a 

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metric that many lenders and 
rating agencies use as a gauge 

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00:14:28,520 --> 00:14:31,960
of whether companies can service
their debts with operating 

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profits. 
Higher interest rates, combined 

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with inflation and a slowing 
economy could lead to more PE 

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backed companies running into 
trouble. 

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PE funds that have been 
struggling to exit their 

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portfolio companies have turned 
to financial engineering 

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strategies, essentially adding 
new layers of leverage to make 

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the strategy seem more 
attractive to investors. 

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Many have been taking Net Asset 
Value loans, or NAV loans, which

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involve borrowing against the 
portfolio of assets inside their

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funds, an extra layer of debt on
top of an already levered 

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portfolio. 
If these NAV loans are used to 

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send cash distributions to PE 
fund investors, the managers can

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00:15:18,040 --> 00:15:22,360
be criticized for layering on 
leverage to make payouts and for

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attempting to obscure to their 
investors the underperformance 

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or unsellability of their 
underlying portfolio companies. 

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An industry insider told the FT 
last week that the PE firms with

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the strongest performance are 
less likely to be the ones 

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00:15:39,440 --> 00:15:42,040
involved in these financial 
shenanigans. 

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Rising long term interest rates 
can be expected to put pressure 

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on private real estate 
valuations too, where firms such

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as Blackstone and Brookfield 
have become some of the largest 

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00:15:54,600 --> 00:15:58,200
property owners globally. 
I discussed the difficulties 

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00:15:58,200 --> 00:16:02,080
being faced at the Blackstone 
Real Estate Income Trust on this

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00:16:02,080 --> 00:16:06,360
channel a few months ago. 
The sectors that historically 

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have performed best in a rising 
rate environment are financials,

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00:16:10,840 --> 00:16:15,600
healthcare and consumer staples.
These are typically described as

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00:16:15,600 --> 00:16:19,720
defensive stocks that generate 
steady earnings regardless of 

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00:16:19,720 --> 00:16:21,680
the state of the overall 
economy. 

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00:16:22,240 --> 00:16:25,520
The worst performing sectors 
historically have been real 

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00:16:25,520 --> 00:16:29,280
estate and consumer 
discretionary real estate is 

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00:16:29,280 --> 00:16:32,760
often bought with borrowed money
so suffers when the cost of 

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00:16:32,760 --> 00:16:36,120
borrowing increases. 
The consumer discretionary 

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00:16:36,120 --> 00:16:39,920
sector is made-up of companies 
that produce and sell non 

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00:16:39,920 --> 00:16:43,440
essential goods and services. 
These are things people don't 

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necessarily need and can do 
without when times get tough. 

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If we look at a breakdown of 
value stocks versus growth 

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stocks. 
We find that both groups are 

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interest rate sensitive, but for
different reasons. 

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00:16:57,520 --> 00:17:02,440
A 2017 paper from Regensburg 
University found that growth 

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00:17:02,440 --> 00:17:06,680
stocks are much more sensitive 
to changes in long term interest

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00:17:06,680 --> 00:17:09,640
rates. 
This is consistent with the idea

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that cash flows that are 
expected to arrive in the 

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00:17:12,680 --> 00:17:17,040
distant future become a lot less
valuable as you discount them at

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00:17:17,040 --> 00:17:19,040
higher and higher interest 
rates. 

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00:17:19,359 --> 00:17:22,599
In the zero interest rate 
environment of a few years ago, 

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a dollar received in 10 years 
was worth about the same as a 

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00:17:26,400 --> 00:17:30,640
dollar received the next day. 
That is no longer the case. 

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00:17:30,920 --> 00:17:34,480
In contrast, the more front 
loaded cash flows of value 

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00:17:34,480 --> 00:17:38,360
stocks are less impacted by 
higher discount rates. 

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00:17:39,200 --> 00:17:43,360
On the other hand, most growth 
stocks are entirely equity 

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00:17:43,360 --> 00:17:46,640
funded as they don't generate 
sufficient cash flows to be 

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00:17:46,640 --> 00:17:50,240
eligible for loans. 
While value stocks tend to use 

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00:17:50,240 --> 00:17:54,800
more leverage, value stocks that
need to roll a bond in the near 

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00:17:54,800 --> 00:17:58,240
future will find themselves 
paying a much higher interest 

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00:17:58,240 --> 00:18:02,160
rate going forward, and their 
cost of capital can be expected 

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00:18:02,160 --> 00:18:04,520
to rise along with interest 
rates. 

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00:18:04,880 --> 00:18:09,600
The cost of equity capital will 
also go up for all firms, both 

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00:18:09,600 --> 00:18:12,840
value and growth, as interest 
rates rise. 

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00:18:13,160 --> 00:18:17,040
Equity investors demand a 
premium above the risk free rate

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00:18:17,040 --> 00:18:20,360
to compensate them for the 
additional risk they're taking. 

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00:18:20,960 --> 00:18:24,640
Jerome Powell tried to paint a 
balanced picture of the 

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00:18:24,640 --> 00:18:28,440
challenge facing the Fed in a 
speech before the Economic Club 

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00:18:28,440 --> 00:18:32,480
of New York earlier today. 
He emphasized that the Fed is 

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00:18:32,480 --> 00:18:35,560
trying to weigh two goals 
against one another. 

292
00:18:35,920 --> 00:18:39,760
It wants to wrestle inflation 
fully under control, but it also

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00:18:39,760 --> 00:18:43,760
wants to avoid doing too much, 
unnecessarily hurting the 

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00:18:43,760 --> 00:18:47,360
economy. 
We're attentive to recent data 

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00:18:47,360 --> 00:18:51,080
showing the resilience of 
economic growth and demand for 

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00:18:51,080 --> 00:18:55,080
labour, Mr. Powell acknowledged 
in his prepared remarks. 

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00:18:55,480 --> 00:18:59,320
Additional evidence of 
persistently above trend growth 

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00:18:59,560 --> 00:19:03,120
or that tightness in the labor 
market is no longer easing, 

299
00:19:03,320 --> 00:19:07,520
could put further progress on 
inflation at risk and could 

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00:19:07,520 --> 00:19:10,640
warrant further tightening of 
monetary policy. 

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00:19:11,120 --> 00:19:13,720
Thanks for tuning into this 
week's podcast. 

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00:19:13,840 --> 00:19:16,640
Have a great week and talk to 
you again soon. 

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00:19:16,800 --> 00:19:20,200
Bye. 
If you enjoyed this episode, be 

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00:19:20,200 --> 00:19:23,040
sure to subscribe so you're 
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305
00:19:23,040 --> 00:19:25,280
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306
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307
00:19:27,760 --> 00:19:31,240
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308
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309
00:19:35,720 --> 00:19:38,320
at Patrick E Boyle. 
Thanks for listening. 

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00:19:38,360 --> 00:19:38,760
Bye.