When the yield on a government bond rises, the price of almost everything else is quietly revised. Shares, property, corporate credit and currencies are all measured against the return an investor can earn without taking risk, so when that benchmark moves, every other price has to be recalculated. This is why a shift in the bond market can unsettle share markets even when nothing about the underlying businesses has changed.

One rate sits beneath every price

A government bond yield is often called the risk-free rate. It is the return available from lending to a government, and every other investment is judged by how much more it must offer to justify its extra risk. That judgement shows up in two ways.

The first is a simple comparison. The earnings yield on a share is the inverse of its price-to-earnings ratio, and for roughly twenty years it has sat well above the yield on government bonds. As bond yields have climbed, that gap has closed and, in both the United States and Australia, reversed. The marginal investor now has a credible alternative with far less risk.

The second is mathematical. Most valuation methods, including discounted cash flow models, estimate what a business is worth today by taking its expected future earnings and discounting them at a rate built from two parts: the risk-free yield, and a premium for the particular risks of that company. Raise the risk-free yield and the same stream of future profit is worth less today. Nothing about the business has deteriorated. The arithmetic has changed.

Property follows the same logic. Cheap borrowing let buyers pay more and made a long wait to sell seem low-risk. Dearer borrowing reduces what buyers can borrow and raises the cost of holding an asset for years.

Why capital is becoming scarcer

In the years after 2019, money was close to free. Governments were creating it, borrowing costs were negligible, and an investor who wanted seven or eight per cent on their capital had few places to look. Term deposits paid around half a per cent and government bonds around a quarter of a per cent, so the share market was the obvious answer. Those conditions flattered every asset.

That has reversed, and for several reasons at once. Higher oil and diesel prices lift inflation expectations, which push nominal yields up. Uncertainty about the path of interest rates adds a term premium to longer-dated bonds. Large deficits and growing government debt mean more bonds must be sold, and buyers want more to hold them. And a wave of corporate borrowing to fund large-scale technology investment, much of it issued over long terms, competes with governments for the same pool of savings. Economists call this crowding out. Long-dated US government bonds have recently yielded 5.4 to 5.7 per cent, and term deposits and business borrowing costs have followed.

Whether higher yields make bonds more attractive than shares depends on why yields are rising. A bond bought at five and a quarter to five and a half per cent gives a fair guide to its five-year return. But if inflation is the driver, businesses that earn nominal revenues can hold up better than bonds. The cause of the move matters as much as its size.

The balance sheet decides who carries the burden

Higher yields are not equally uncomfortable for every company, and the difference is largely a matter of debt. Consider two businesses in health care, where demand has nothing to do with bond yields. One carries debt of roughly an eighth of its equity. The other carries more than twice its equity. Demand for both is steady. But the second now faces an interest bill two to three times larger, and because shareholders are entitled only to what remains after interest is paid, its profit falls however well management performs.

The structure of debt matters as much as its size. A company that locked in a long-dated, fixed-rate bond at a low rate carries a cost that does not rise with yields, and in an inflationary period the real burden of that debt shrinks over time. Debt that must be refinanced soon is a different matter. At the extreme are lenders who themselves borrow heavily to fund their loan books. Where a business owes twenty dollars for every dollar of equity, a small rise in what it pays on its borrowings can consume most or all of the profit available to shareholders.

Thinking one step further also helps. The obvious reading of higher rates and dearer diesel is that transport suffers. But operators who defer an expensive new truck keep their older ones running for another year or two, and the businesses that supply parts for ageing fleets can see demand rise. The first effect and the second can point in opposite directions.

Why cheap money kept weak ideas alive

A long period of low rates allowed weak ideas to persist. A business that could show revenue or growth could fund its losses almost indefinitely, because repayment seemed a long way off. The economist Joseph Schumpeter described capitalism as a process of creative destruction, in which booms and busts shake out unproductive assets and move capital to better ideas. With no major shake-out since 2007 and 2008, many unproductive ventures have kept absorbing labour, capital and resources.

Competition shows the effect clearly. When any entrepreneur can borrow to open a café that does not need to make money, a well-run café must share its customers with seven others. When funding tightens and several of them close, the same customers are shared among fewer, and the survivors benefit.

Price remains the other half of the picture. The long-term average price-to-earnings ratio of the market has been between 18 and 20, and most companies trade between 15 and 30 times earnings. When a company’s multiple sits far above its own history and the market’s, history suggests the gap tends to close, and it can close in the other direction too when a multiple is unusually low.

Rising yields are best understood as a repricing rather than a verdict. They reduce what future profits are worth, they reward balance sheets that were built with care, and they remove capital from businesses that depended on it being free. The investor’s task is to separate the businesses that are merely repriced from the businesses that cannot carry the new cost of capital, and to be patient about which is which.

Teaminvest Takeaway

At Teaminvest, we treat a rising cost of capital as one of the market’s regular stress tests. Our research starts with the balance sheet because highly indebted companies are the most common Capital Killers® when markets fall, and Conscious Investor® lets members see that risk before a share price does. Volatility is a friend to the patient investor, because it hands us great companies at lower prices. We research slowly and move quickly only when price and value meet, knowing that a good company missed at a fair price tends to come around again in another 12 to 18 months.

Closing note

This topic was covered in Episode 36 of Wealthy + Wise on the Teaminvest Wealth Builders channel. Watch the full episode on YouTube or listen via Buzzsprout.

General information only. Not financial product advice. Teaminvest Pty Ltd, part of TIP Group (AFSL 334339).