Who cares about rising rates?

December 14, 2012

At this week’s Dealbook Conference,  Lloyd Blankfein, David Rubenstein and Ray Dalio each fretted about a “bond bubble”.  This isn’t necessarily a new or unique fear. It was already a “constant refrain” in 2010. Jeff Gundlach exemplifies a more extreme version of the same point, and it’s been recently covered in the FT and WSJ.  Here’s Blankfein:

“I think [investor complacency about low interest rates] is one of the big risks that are looming out there right now…What’s going to happen when growth picks up and interest rates rise? There’s going to be a reversal and people will have losses.”

Blankfein is right: if you’re a fixed-income investor, rising interest rates are a risk. That statement is correct now, but it’s also always correct; There’s no way rising rates can’t not be a risk to bond buyers. The same goes for inflation, which bond-investor extraordinaire Bill Gross is worried about.

In the wake of the financial crisis, it’s easy to hear the phrase “bond bubble” and think economy stability is at risk. Blankfein feeds into this perception when he says that “one of the big risks that is looming… is that people are once again complacent about this low level of interest rates”. That sounds scary in isolation, but in context  his comments are actually positive. The bubble will be over, he says, when “growth… come[s] back”. But Fortune cut that crucially important caveat when it published its story. Blankfein and others’ worries might sound like they are meant for a wide audience, but the idea that the bond bubble is a risk is a message aimed squarely at bond portfolio managers.

They should be worried, because there really isn’t anyway other direction for interest rates to move other than up. After all, corporate borrowing rates are at the lowest they’ve been since before the financial crisis10-year Treasury rates are hovering at the pace of inflation, and the Fed funds rate will be 0.0-0.25% for the foreseeable future.

But for the rest of us, this is all good news. For one thing, American companies have decided to issue record amounts of high-grade debt. They’ve got some serious ground to make up — S&P estimates that US companies underinvested by $175 billion from 2009-2011. It was worrying when rates were low and companies weren’t increasing their borrowing. Now that they’re borrowing more, it’s a good thing.

If corporate America’s new capital manages to generate growth and create jobs, borrowing rates and inflation will rise, and that in turn will be a sign that things are getting better, not worse. Right now, the Fed is holding rates low because economic growth is weak and unemployment is too high.  Similarly, inflation remains low because of slow growth. The Bank for International Settlements, noting the current low level of corporate rates, makes this connection: borrowing rates fell “as forecasters cut their projections for global economic growth”.

Is there a bond bubble? In the sense that rates are historically low, and companies and governments are borrowing a lot, yes.  Should you be worried about it? Only if you’re a fixed-income asset manager.

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