bitez

by Standard Chartered’s Global Chief Investment Office

Adapting to an
environment ofhigher interest
rates
Audrey Goh
Head of Asset Allocation and Thematic StrategyThe relentless rise in bond yields
has been the main theme inmarkets over 2022 and 2023. Since
the beginning of 2021, the nominal US
10-year government bond yield has
risen from 1.5% to a peak just above
5% in October. The real yield, whichis calculated by subtracting inflation
expectations from nominal yields,
has risen from -1.02% to around 2.5%.
While these may seem like abstract
figures, they hold significant real-world
implications.
To put things into perspective, it isunusual for real yields to linger above
2.5% for an extended period. In fact,over the past two decades, they
averaged above this threshold forless than 9% of the time. The period
between 2003 to 2007 saw real
yields hovering over 2%, but the tide
turned with the Fed’s bond purchases
following the Global Financial Crisis,
which drove yields below 0.5% from2009 to 2020. In 2023, real yields haverebounded to around 2.5%.
There are three implications thatinvestor needs to consider in a worldof rising bond yields and high interest
rates:
Rethinking capital allocation
for companies
As the cost of capital escalates,
companies need to reconsider their1capital allocation strategies. The costof marginal debt for firms has seen asignificant uptick, with the average US
investment grade and sub-investment
grade (or “high yield”) companies now
funding themselves at around 6% and
9% interest rates, respectively. This
stands in stark contrast to just three
years ago when the figures stood ataround 2% and 4%. The cost of equity
for firms has also risen, even though it
is not directly visible. Both the cost ofequity and cost of debt play a pivotal
role in determining a company’s

overall cost of capital, the benchmark
companies use to determine whether acapital project is worth pursuing.
With a higher hurdle rate, fewer projects
will look attractive, and companies
may become more discerning whenchoosing which projects to invest
in. This could inevitably lead to a
slowdown in earnings and a shift awayfrom high-risk, high-reward ventures infavour of more stable and predictable
investments. Furthermore, companies
mayincreasingly
lean
towards

returning more capital to shareholders
through dividends and share buybacks,
which can be a more efficient use ofcapital, typically providing returns inline with the cost of equity capital.
Investors to become more
selective
Higher bond yields compel investors
to take a more selective stance. The
US 10-year government bonds now
offers above 4% nominal yield andclose to 2.5% real yield, making them
enticing investments for many. As aresult, investors will need to consider
how much risk they want to take intheir portfolio going forward. Overthe past decade, low interest rates
made owning equities and other risky
assets a necessity, but the case looks
less compelling now. These shifts inpreferences often tend to take years to
fully unfold.

2

The repercussions of higher bond yields
also extend to the realm of equity
valuations. Higher bond yields argue forlower equity valuations, all other things
remaining unchanged. Higher rates
diminish the value of future cash flows
at the firms. As demand for equities
decline, equity price multiples typicallycontract. However, such effects may
take time to fully materialise.

Where yields go from here
matters
While long-term real yields are
currently sitting at the upper end of
their historical ranges, uncertainty
around whether they will continue torise or potentially decline looms large.
Our model tracking investor diversity
suggests the possibility of a pullback inyields over the next 12 months. However,
if yields break out higher, investors may
become more uncomfortable withowning bonds, much like a trader who
would short a stock as it makes a multiyear high.

3

I see the risks to bond yields asbalanced. There are valid arguments
for both real yields to break out to
new highs and for yields to decline
from their current levels. Persistent
US budget deficit, the Fed continuing
to reduce its holding of government
bonds, and the upside momentum
to bond yields are supportive of evenhigher bond yields in the near term. On
the other hand, history suggests real
yields are likely to decline if US growthsignificantly moderates as we expectfrom Q4. It is difficult to envisage the
US maintaining the robust 4.9% GDP
growth reported for Q3. Meanwhile,
any escalation in geopolitical risks
could trigger safe haven demand for

US government bonds, lowering theyields on offer.
External factors can also sway thecourse of bond yields. In the second
half of 2023, investors have increasingly
demanded higher yields to holdUS government bonds after the US
Treasury surprised the market with new
budget deficit estimates and ramped
up bond issuances. Uncertainty overthe demand/supply dynamics for US
government bonds suggests bondyields may not fall significantly in thenear term. However, over the next
6-12 months, long-dated bonds could
prove attractive in an environment
characterised by decelerating inflation,
slowing economic growth, and agreater likelihood of the Fed opting forrate cuts.

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