The Bond Market has Revised its Quote

They lend money, collect interest and spend an unusual amount of time discussing inflation expectations in fractions of a percentage point.

Until, that is, they change the price of money for almost everybody.

Government bond yields have risen sharply across developed markets. The Australian 10-year government bond yield has reached its highest level since 2011, while the US 30-year Treasury yield has climbed to its highest in around two decades.

There is no single explanation.

Inflation has proved more persistent than many expected. Governments are borrowing heavily. Businesses are competing for capital to fund increasingly expensive investment programs. Investors also want greater compensation for lending over long periods when the economic and policy outlook is difficult to price.

Japan matters too.

For decades, exceptionally low Japanese interest rates encouraged the country’s banks, insurers, pension funds and households to invest substantial amounts offshore. As Japanese yields rise, investors there have a more credible alternative at home. Overseas borrowers may therefore need to offer more to attract their next dollar. We explored that changing equation recently in our article Why Rising Japanese Interest Rates Matter to Australian Investors.

The rise in global yields has prompted plenty of talk about a bond-market crisis.

There are certainly risks worth taking seriously. Government interest bills are rising. Businesses with substantial debt will eventually need to refinance. Higher long-term rates can weigh on shares, property and infrastructure because the income from those assets must compete with a better return available from bonds.

But higher yields do not necessarily mean bond markets have stopped functioning.

There is an important difference between a crisis and a repricing. In a crisis, liquidity disappears, markets become disorderly and capital struggles to move. In a repricing, markets continue to function, but borrowers must accept that the terms have changed.

At present, the latter may be the more useful way to understand what is happening.

Governments and businesses would like to borrow more money, for longer, in a world where inflation, fiscal policy and the supply of capital are less predictable. Investors would like to be paid accordingly.

The bond market has revised its quote.

This creates pressure, but also opportunity.

Higher yields raise financing costs and the hurdle rate applied to new investments. Businesses able to fund growth internally are in a different position from those that must repeatedly return to lenders. Property supported by durable income looks different from property relying heavily on cheap debt and rising valuations.

Higher yields also increase the income available to investors willing to lend.

After years in which defensive assets offered very little, bonds once again provide a more meaningful return. Starting yields are more attractive than they were during the ultra-low-rate era, although further increases in yields can still produce capital losses in the short term.

The larger change is that capital allocation matters again.

When money was exceptionally cheap, a great many assets benefited. Falling yields supported higher valuations, encouraged borrowing and pushed investors towards shares, property and infrastructure in search of income.

Today’s environment is less accommodating.

Valuations matter more. Debt matters more. The durability of cash flow matters more. So does the ability of management to decide which projects deserve capital and which merely became possible because borrowing was inexpensive.

The bond market is not necessarily sounding an alarm.

It may simply be reminding borrowers that money was never meant to be free.