Yield of discontent

It can seem counter-intuitive, but rising bond yields reflect investor worry. (After all, aren’t higher yields attractive?)

At the same time, investors’ bagful of anxieties is running headlong into greater demand for borrowing than at any time in human history.

It’s a full-course meal of mayhem: trade wars, unending real wars, accelerating government budgets and big tech companies borrowing as much as they can to achieve artificial intelligence supremacy.

Don’t forget the orange zest of economic unrest: an unpredictable, often incomprehensible president of the United States.

“It’s sort of like drip, drip, drip, water torture with U.S. debt levels, which now passed US$40 trillion,” says John De Goey, portfolio manager with Designed Wealth Management Inc.

Debt levels, however, are a sideshow behind rising bond yields, says De Goey, Toronto-based author of Bullshift: How Optimism Bias Threatens Your Finances.

“The main reason is (U.S. President) Donald Trump is trying to drive the American economy into the ditch.”

Altogether, these translate into higher costs for borrowers — governments, corporations and consumers — because lenders want more compensation for these risks.

If you own bonds, their value decreases as yields rise because their prices must adjust downward to be able to pay a prospective buyer today’s higher yield.

Roughly speaking, if you own $100 of bonds with a coupon (interest) payment of three per cent, and yields increase to four per cent, that value drops to about $97.

Yields can rise for many reasons; not all are bad.

Bond yields can rise gradually when the stock market does well. More investors sell bonds, depressing prices and increasing yields, to purchase stocks instead.

That has been happening because the stock market is still near record levels.

Increasingly, rising yields reflect bad mojo sentiment.

Inflation fears are part of that, driving yields higher. That is because inflation exceeding normal levels (higher than three per cent) increases the likelihood central banks will hike policy interest rates to slow borrowing and, consequently, slow economic growth.

Under normal circumstances, inflation is caused by growth — a good thing.

Today “central banks are in between a rock and a hard place,” says Kimberly Hart, director of manager research in Canada for Morningstar in Toronto.

They see plenty of inflation drivers, including a strong U.S. economy. Other drivers are not pro-growth like tariffs and the Iran War.

Central bankers also recognize consumers are struggling, and higher rates increase their struggle.

In turn, central banks face a “nightmare scenario: stagflation,” where they could be forced to raise rates to slow inflation not caused by economic growth but by higher prices resulting from geopolitical factors, amid economic decline, she says.

Another inflationary ingredient is the AI race.

Google, Microsoft, Nvidia and other tech companies seek to borrow as much as US$3 trillion to build data centres. They’ve already borrowed more than US$700 billion, driving bond yields higher.

This scenario illustrate supply-and-demand economics, says Konstantin Boehmer, head of fixed income at Mackenzie Investments in Toronto. “There’s a ton of government bonds coming out because the U.S. has to finance itself, but all of the (AI) hyperscalers are tapping the U.S. market for funding at the same time.”

More borrowers competing for money means lenders (investors) can demand higher yields.

Consumers also take a hit.

Higher yields impact fixed mortgage rates, automobile and other loans, says David-Alexandre Brassard, chief economist at Chartered Professional Accountants of Canada in Quebec City. “There’s a disconnect between the policy rate and bond yields.”

The Bank of Canada overnight rate, which dictates variable rate mortgages and lines of credit, has remained steady at 2.25 per cent. Yet five-year fixed mortgage rates are set according to five-year government bond yields, which are about 3.4 per cent.

“If bond yields go higher, that spread is bigger, making fixed mortgages more expensive than variables,” he says.

Brassard points to another consumer pain point: as yields rise, so do interest payments on government debt.

Already, Canada pays more than $90 billion annually in interest on about $1.4 trillion in debt. (By comparison, U.S. taxpayers pay that much interest in a month.)

Canadians’ investment portfolios also can be negatively affected. Bond holdings fall in value, but so can equity values, says Darrin Erickson, portfolio manager at Value Partners Investments in Winnipeg. “A lot of investors look to yields as an indication of where the equity market will go.”

It’s not that something awful will happen like banks collapsing 2008-style — though yields did rise substantially over several months before that market crash.

Erickson says it’s more about the financial math.

Higher yields can make bonds more attractive than stocks, especially those paying dividends. But they also diminish the projected future value of revenues of growth stocks, including technology because investors are less willing to pay a premium for future upside.

Rising yields also affect companies’ debt levels. Indebted companies pay more interest, becoming less profitable and less likely to borrow to grow, he says.

Higher yields are not necessarily a doomsday scenario.

Boehmer says long-term bond yields are now reaching heights that pension funds and other institutional investors are considering purchasing them.

That’s because their real yield, after accounting for inflation, is getting close to three per cent, which is an attractive proposition for a long-term horizon, he says.

Indeed, higher yields can be a good situation for investors seeking to purchase bonds.

Should that happen, yields will fall as demand rises for bonds, as the price increases as more investors compete to buy them.

For now, however, the uncertain state of the world is likely to keep yields elevated.

Erickson suggests investors own diversified portfolios, spreading out risk and casting a wide net to catch opportunity.

“You want to own companies in different industries that complement each other,” he says about stocks. “Focus on high-quality, durable businesses that are going to continue to generate profits.”

After all, well-run businesses often grow … even in high-yielding, anxious times like these.

Joel Schlesinger is a Winnipeg-based freelance journalist

joelschles@gmail.com