Hello and welcome you are listening to Patrick Boyle on
Finance, a podcast exploring ideas from quantitative finance,
examining events occurring in markets right now and financial
history to see what lessons can be taken away, including
interviews with some of the most interesting people in the world
of finance. To learn more about the podcast,
visit on finance.org. The 10 year U.S.
Treasury yield closed above 4.9% yesterday, its highest level
since July 2007. While that might not seem like a
big deal to most investors, 4.9% is not really a surprisingly
high interest rate in the greater scheme of things.
What it means is that bond investors in longer dated
Treasuries have lost around half of their money since early 2020.
A-Team of analysts at Bank of America are calling this the
greatest bond bear market of all time, The Long Term Treasury ETF
which invests in U.S. government debt maturing in at least 10
years. Is down 8 1/2% over the last
month and it's half since its high in March 2020.
That would be considered a terrible loss in the stock
market, which is at least expected to be volatile.
It's a devastating loss for bond investors, who are typically
seen as being risk averse investors seeking stable returns
and income. The current losses in long
maturity debt more than double the losses that occurred in
1981, when Paul Volcker's campaign to end persistent
inflation drove 10 year Treasury yields to almost 16%.
Since 1945, there have only been 3 stock market drawdowns of 40%
or more, the most recent two being the bursting ofthe.com
bubble and the financial crisis of 2000 and seven 2008.
So what's happened in the bond market is one of the ugliest
losses in modern financial history.
The financial press is describing these as paper
losses, as if you hold on to the bonds you bought at near 0
interest rates. You do eventually get the money
that you put in back when the bonds mature.
You locked it up at close to 0% for 10 years or more, and that's
exactly what you get. No return over a long period of
time. That doesn't look great in this
inflationary environment, however.
The fact that investors can buy a bond that yields 4.9% today is
the reason that the bonds bought in 2020 when interest rates were
near 0 have to be sold at a big discount today if you want out
of them. It's hard to believe that the
federal funds rate was near 0 as recently as the first quarter of
2022. The Fed was still buying
billions of dollars of bonds every month to stimulate the
economy back then as well. All of this despite 40 year
highs in various measures of US inflation.
Once the Fed began hiking rates, it moved forcefully.
But the rate that the Federal Reserve controls is a short term
interest rate when investors believe that inflation would be
brought quickly under control. Longer dated interest rates
stayed low on the expectation that as soon as inflation was
defeated that the Fed would begin cutting rates once again.
Investors now believe that rates will stay higher for longer.
So if the Fed only sets short term interest rates, who sets
longer term rates? Well, academics argue that
yields on long dated bonds are determined by the anticipated
path of short term interest rates.
The idea is that investors would buy a series of one year bonds
rather than a 10 year bond if they believe that doing so would
produce a better return. If they're unwilling to buy
longer dated bonds, bond issuers will need to offer a higher
interest rate until buyers emerge.
This supply demand dynamic means that investors and borrowers
interest rate expectations determine long term interest
rates. These rates settle at levels
where investors are indifferent between buying a series of short
term bonds or just buying the long term bond.
Other factors also influence yields.
Investors typically demand some extra yield to compensate them
for taking the risk of tying their money up for a long time,
due to the possibility that rates could end up higher than
they expect today. Additionally, yields can be
influenced by the supply of government bonds.
If the government wants to borrow a lot this high demand
for investors, capital can push yields up.
Demand will matter, too. Foreign central banks have grown
their reserves a lot over the last 20 years.
If they're expected to stop growing their reserves, there
would be less demand for bonds and interest rates would rise.
Quantitative tightening by the Federal Reserve, who have
stopped buying bonds and are allowing their existing
portfolio to mature, is another factor reducing demand for
bonds. Sometimes investors will accept
a lower yield on longer dated bonds, known as a negative term
premium, because they expect an economic slowdown which will
then lead to interest rate cuts. And those new lower rates will
make the bonds that they bought back when interest rates were
higher more valuable. Now that borrowing costs have
reached their highest levels in over 15 years, let's look at who
benefits and who feels the pain at these new, higher interest
rates. Treasury yields Dr. the interest
rate on everything from mortgages to corporate debt.
And for this reason, the new higher rates that we're seeing
have become a source of anxiety for investors.
So far, their worries have mostly been unfounded, as the
economy has shown little sign of buckling under the higher
borrowing costs. Higher bond yields can also have
the effect of making riskier assets like stocks seem less
attractive, as investors can now earn a reasonable return
investing in bonds. A few years ago, people used to
argue that there was no alternative to investing in the
stock market. Now there is.
Inflation today stands well below its peak last year of over
9%, but it stubbornly remains more than a percentage point
higher than the Federal Reserve's target rate.
The move in longer dated bond yields is driven largely by an
acknowledgement among investors that inflation may be more
persistent than they had initially expected, which could
keep interest rates higher for longer.
Worries over large government spending plans and high
borrowing requirements in the United States have pushed yields
higher, too. Investors are concerned about
government spending as while rates have been at 5% or much
higher in the past, they've never been at that level, with
$33 trillion in debt outstanding.
So first up, how will the consumer be affected by higher
interest rates? Well, mortgage rates today stand
at their highest level in more than 20 years.
The average interest rate on credit cards tops anything on
record at the Federal Reserve. Car loans have returned to 2008
levels, too. Each percentage point increase
in a mortgage rate can add thousands or 10s of thousands of
dollars in additional interest rate expense to borrowers,
depending on the size of the mortgage.
This can be expected to weigh on real estate prices, as the cash
flow required to buy a house at a given price point today is
considerably higher than it was a year or two ago.
A lot of American homeowners who want to move house have decided
to stay put, as moving house usually involves paying off your
mortgage and then borrowing again at the new, higher
interest rate. Doing this would involve either
higher monthly mortgage bills for an equivalently priced
house, or buying a cheaper home than the one that you're
selling. For this reason, a lot of
homeowners are deciding to spend money on home improvements
rather than moving house. This morning we saw that US
existing home sales have fallen to their lowest level since
2010. The impact of higher bond yields
on the consumer is mixed, as those who borrow money will feel
a squeeze, while individuals with savings will benefit from
earning higher returns on their cash in money market accounts or
the bonds they can invest in. Different businesses have
different interest rate sensitivity to financial firms
like banks. Insurance companies, brokerage
firms and money managers historically have done well when
interest rates move higher. Banks, for example, get to
collect higher interest rates from borrowers while keeping
deposit rates low. This time around, higher rates
haven't worked as well for banks as they did in the past, as we
saw in the regional banking crisis earlier this year, where
a number of banks had locked up money at low interest rates and
their depositors began pulling their deposits for a variety of
reasons. Third quarter profits at Bank of
America that came out a few days ago beat expectations, but the
bank's growth lagged to other large banks.
As Bank of America still has hundreds of billions of dollars
of low yielding bonds that it bought during the pandemic
losses on American banks, bond portfolios have drawn a lot of
attention this year. These mark to market losses are
now close to $400 billion. An all time high and 10% above
the peak at the start of this year that caused the collapse of
Silicon Valley Bank. Most banks, and in particular
the largest ones, won't have to sell any of these bonds.
And so we'll never realize these losses, but because they locked
money up at low rate, they're now missing out on the higher
rates they could have earned, which will be a drag on
profitability. Life insurance companies are big
holders of bonds, too, which they use to back liabilities
like pension obligations. Like banks, most of these firms
can often hold their existing bonds to maturity,
underperforming because they locked up their money at low
rates but not being forced to sell.
Their worry is that a rapid rise in rates might encourage their
customers to cash in long term products, forcing them to sell
bonds and other matching assets at a loss.
In general, higher bond yields are good news for defined
benefit pension funds because it improves their funding position.
US defined benefit pension funds have about 3 1/2 trillion
dollars in assets on their management.
Their funded ratios are above 100% sustainably for the first
time since the financial crisis, and their fixed income
allocations have been rising for the past decade or more.
These funds were really struggling back in 2011 or 2012
when they're funded ratios were well under 100% and their fixed
income asset allocation was around 35%.
These fixed income allocations are now over 50% according to
research from JP Morgan, and could quite likely grow.
The speed of this interest rate increase means that many of the
portfolio managers are likely taking their time to add
duration to their portfolios and are waiting to see volatility
decline before making a bigger commitment.
Corporate debt markets have come under a lot of pressure as
government bond yields have been rising too.
The average yield on US junk bonds has been above 9% since
the end of September. Credit spreads, A barometer of
default risk, have been rising too.
The moves have been most extreme at the riskiest end of the
credit spectrum. There are a lot of companies who
wisely took advantage of ultra low interest rates during the
pandemic to borrow cheaply and push out maturities so that they
don't have to refinance for quite a while.
However, a lot of debt will start coming due in the next two
to three years. Junk rated loans, which have
floating interest rates, have already been feeling the effects
of higher interest rates. Rising yields put the most
pressure on the most levered companies and you might start to
see a higher default rate from companies that have managed to
scrape by, mostly due to the cheap financing they were able
to get in the past, which is not available today.
For the past 20 years, private equity has been a relatively
simple business of buying a company using cheap debt and
long term capital from investors.
Sustained high interest rates are bad news for that business
model on a number of fronts. Leveraged buyouts obviously rely
on leverage it in the name and as the cost of that leverage
rises, the deals that can be done are a lot less attractive.
The slowdown in the deal cycle has made it more difficult for
PE firms to sell assets and return money to their investors.
The ability of the companies that they've invested in to
service their debt loads is also becoming more strained right
now. Researchers at Carlyle Group
have warned that the rising cost of debt has dramatically lowered
interest coverage ratios across the private equity universe, a
metric that many lenders and rating agencies use as a gauge
of whether companies can service their debts with operating
profits. Higher interest rates, combined
with inflation and a slowing economy could lead to more PE
backed companies running into trouble.
PE funds that have been struggling to exit their
portfolio companies have turned to financial engineering
strategies, essentially adding new layers of leverage to make
the strategy seem more attractive to investors.
Many have been taking Net Asset Value loans, or NAV loans, which
involve borrowing against the portfolio of assets inside their
funds, an extra layer of debt on top of an already levered
portfolio. If these NAV loans are used to
send cash distributions to PE fund investors, the managers can
be criticized for layering on leverage to make payouts and for
attempting to obscure to their investors the underperformance
or unsellability of their underlying portfolio companies.
An industry insider told the FT last week that the PE firms with
the strongest performance are less likely to be the ones
involved in these financial shenanigans.
Rising long term interest rates can be expected to put pressure
on private real estate valuations too, where firms such
as Blackstone and Brookfield have become some of the largest
property owners globally. I discussed the difficulties
being faced at the Blackstone Real Estate Income Trust on this
channel a few months ago. The sectors that historically
have performed best in a rising rate environment are financials,
healthcare and consumer staples. These are typically described as
defensive stocks that generate steady earnings regardless of
the state of the overall economy.
The worst performing sectors historically have been real
estate and consumer discretionary real estate is
often bought with borrowed money so suffers when the cost of
borrowing increases. The consumer discretionary
sector is made-up of companies that produce and sell non
essential goods and services. These are things people don't
necessarily need and can do without when times get tough.
If we look at a breakdown of value stocks versus growth
stocks. We find that both groups are
interest rate sensitive, but for different reasons.
A 2017 paper from Regensburg University found that growth
stocks are much more sensitive to changes in long term interest
rates. This is consistent with the idea
that cash flows that are expected to arrive in the
distant future become a lot less valuable as you discount them at
higher and higher interest rates.
In the zero interest rate environment of a few years ago,
a dollar received in 10 years was worth about the same as a
dollar received the next day. That is no longer the case.
In contrast, the more front loaded cash flows of value
stocks are less impacted by higher discount rates.
On the other hand, most growth stocks are entirely equity
funded as they don't generate sufficient cash flows to be
eligible for loans. While value stocks tend to use
more leverage, value stocks that need to roll a bond in the near
future will find themselves paying a much higher interest
rate going forward, and their cost of capital can be expected
to rise along with interest rates.
The cost of equity capital will also go up for all firms, both
value and growth, as interest rates rise.
Equity investors demand a premium above the risk free rate
to compensate them for the additional risk they're taking.
Jerome Powell tried to paint a balanced picture of the
challenge facing the Fed in a speech before the Economic Club
of New York earlier today. He emphasized that the Fed is
trying to weigh two goals against one another.
It wants to wrestle inflation fully under control, but it also
wants to avoid doing too much, unnecessarily hurting the
economy. We're attentive to recent data
showing the resilience of economic growth and demand for
labour, Mr. Powell acknowledged in his prepared remarks.
Additional evidence of persistently above trend growth
or that tightness in the labor market is no longer easing,
could put further progress on inflation at risk and could
warrant further tightening of monetary policy.
Thanks for tuning into this week's podcast.
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