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. Have a great week and talk to you again soon.
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