In recent weeks there has been a significant shift in the prospects for long-term interest rates. Both the 10-year and 30-year US bond yields have spiked to highs not seen since the GFC in 2007 as the notion of interest rates being higher for longer finally seems to be kicking in. The 10-year US bond rate hit 4.3% and the 30-year US bond yield hit 4.45% up from their lows of under 1% in 2020.
So why is it happening and what does this all mean?
In a normal market, you’d expect the yield on bonds to be higher the longer the term of the investment. However, for the past year or two that hasn’t been the case. The US has had an inverted yield curve with short-term bond yields being higher than longer-term bond yields. That curve is generally associated with a pending recession because when inflation spikes, the bond market expects interest rates to go up in the short term and those higher costs to put the economy into recession. Conversely the expectation is normally that to recover from the recession interest rates will later need to fall to assist a recovery.
These increases in bond yields may seem counter intuitive as they’ve occurred at a time when many investors believe interest rates will come down on the back of falling inflation rates in recent months. However, many other aspects of the global economy remain surprisingly resilient, including unemployment. While that remains the case it’s difficult to realistically expect interest rates to come down just yet. Equity markets especially may be getting ahead of themselves by expecting a continuing decline in inflation back to the target rates of central banks and a subsequent reversal in interest rates.
Now though, it appears the bond market is starting to realise that interest rates are going to be higher for a lot longer. Not a little bit longer. A lot longer. These rates may even be the new normal. When the 10- and 30-year bond yields move like this it is a material shift in the way risk is being assessed. Bond markets are generally very good at assessing and adjusting for risk while equity markets tend to be more optimistic, have more variables to consider and are slower to react. Bonds investors are demanding a higher premium to lend money for the greater risks associated with investment including default.
There is a lot of debt across the world and many nations have huge budget deficits. Those deficits are met by countries issuing even more debt by way of new bond issuances every year. On the back of many years of budget deficits and increasing debt, the rising interest rates across the world means governments that are refinancing maturing bonds will also need to pay a lot more than they were previously. That puts many nations under even more pressure and makes them even less creditworthy.
But in an increasingly competitive debt market for nations and companies, problems arise if there is too much borrowing and not enough investment demand to fund it. It creates a couple of potentially problematic situations. The first problem is that borrowers who are weaker or less credit worthy will have to pay significantly more on borrowings. The second problem arises if nations or companies are not able to secure the funds at all. While government borrowers might be less likely to default when they can issue more bonds in their own currency, this compounds other problems such as inflationary pressures.
The reality is that this recent spike in long-term US bond yields will mean a recalibration of the pricing of all debt across the board. These bonds are the benchmark for what investors consider to be ‘risk-free’ so all other debt is progressively riskier and as such will need to have their pricing adjusted. This means all debt is going to be more expensive. From the bonds of other countries, states, and municipalities to the debt of large, medium, and small corporations, the flow-on effect is significant. Everyone will be paying even higher interest rates as a consequence.
All of this becomes a problem as the weakest of the borrowers in all these different categories start to really struggle. Some may not get finance in the future and that has serious implications for countries and companies where this occurs, and it will occur. This is all part of the slow-motion aftereffects of such rapid rate increases, there are unintended consequences, and the fallout isn’t always manageable. So be wary as to the quality of the bonds or credit investments that you hold in your portfolio and understand that the reason you’re able to get higher returns is due to the higher risk that is embedded in the investments you hold. That risk is real and if you get it wrong it can lead to disastrous outcomes.
General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.