We're Only Ever Right When Markets Agree

The bond and equity markets are telling different stories

Medium and long term bond yields have been rising steadily since February. 10-year US Treasuries now trade at around 4.8%, up from below 4% over six months ago, and up from its 0.65% low in April 2020. The equivalent UK Gilt figures are around 5.2%, up from the February low of 4.2% and the 2020 nadir of 0.25%. A Gilt issued in April 2021 at £1 with a yield of 1.5% maturing in 25 years from now, currently trades at 40p. Meanwhile, over the equivalent period, an investment in the S&P 500 Index has almost tripled in value, while the equivalent UK equity indices have approximately doubled.

In the immediate post pandemic era, these contrary moves appeared entirely justified. Economies had been shut down almost entirely during Covid and the rebounds were dramatic. However, you might remember that central bank interest rate setters in Europe and the US were asleep at the wheel and failed to react to the inevitable inflationary bottlenecks that afflicted previously dormant supply chains. As inflation spiralled out of control, monetary policies were belatedly tightened and interest rates rose quickly from near zero towards their current levels. Although inflationary pressures abated, they have yet to return to their target levels. Therefore, it could be argued that the more recent easing of short-term rates began too early - and certainly before inflation had been squeezed out of the system. This was even before the US attack on Iran and the resulting disruptions to the supplies of energy, helium, sulphuric acid and fertilisers which are placing additional upward pressure on prices.

So today we have bond markets taking fright - not just to future inflation expectations but to a spiral of government borrowing exacerbated by higher borrowing costs. Bonds issued at yields of below 0.5% must be refinanced upon maturity at rates of up to ten times that annual cost. Bond investors are being asked to stump up ever larger sums to fund growing deficits and, given the increased inflation risk, are understandably insisting on even higher rates of interest. This in turn perpetuates the spiral - higher interest costs require additional borrowing which in turn leads to higher interest rates. So, it is not difficult to understand the continued falls in bond prices, but what of equities?

The FTSE 100 Share Index yields a little over 3%, while the S&P 500’s dominance of highly rated technology companies provides a measly 1% annual dividend yield. Despite this historically high yield gap between bonds and equities, many argue that low yields and an index of companies trading at over 30x earnings can be justified by corporate growth prospects. Some even believe this appears cheap when using forward looking earnings. However, the bond market shows how those who are lending enormous sums to build AI Data Centres are pricing the sector’s credit risk. Due to massive bond issuance and declining cashflows, technology sector spreads are now wider than the broader spread investment grade benchmark. However, if we dig deeper into Credit Default Swaps (CDS) we see an even more worrying picture.

CDS provide lenders with insurance protection from a default by the borrower and the pricing is therefore a function of the perceived level of risk that the borrower will be unable to repay the loan. CDS pricing for AI Hyperscalers has surged to record highs. Five-year CDS spreads for major infrastructure spenders like Oracle, Meta, Alphabet, Amazon and Microsoft have widened significantly. For example, Oracle's 5-year CDS trades around 212 to 215 basis points ($212,000–$215,000 annually to insure $10 million of debt), while a composite basket for top technology spenders has climbed roughly 50% to over 160 basis points. So, in an era when large share buybacks have been replaced by equally large requests for support for the raising of additional capital, have the bond markets spotted risks of which equity investors remain strangely unaware?

Widening CDS spreads would typically correlate with falling markets. Indeed, despite the Nasdaq Composite Index continuing to trade near all-time highs, share prices of some Hyperscalers have fallen back - some very substantially, while Nvidia shares continue to trade near their all-time high. I Investors must be aware of two further risk factors:

In many cases, substantial earnings growth has been flattered by the inclusion of book profits on subscriptions and holdings of other companies in the sector, and impressive earnings announcements have seen substantial additional contributions from these one-off sources.

More concerning are the instances of circular financing. For example, Nvidia subscribes for new shares in a company that uses the proceeds to purchase Nvidia’s chips. Another example is the warehousing scheme for chips, paid for upfront but not delivered while data centres are built out - a process that can take some years. These mechanisms appear designed to upfront earnings and mirror certain practices seen during the 1990s Dot-com bubble.

This month Nvidia has signed agreements with six major asset managers and private equity firms - Apollo, BlackRock, Blackstone, Brookfield, Goldman Sachs and KKR - to launch a $500 billion AI infrastructure financing initiative. Critics call this arrangement a giant example of "circular financing", alleging that Nvidia helps channel capital and credit back to clients who use those funds to buy Nvidia's high-end GPUs. In the dot-com era, circular financing was commonly known as "round-tripping." Telecom and Dot-com companies would artificially inflate their revenues by selling network capacity or software to each other, often paired with simultaneous investments or equity swaps of equal value where no net cash actually changed hands.

Whatever conclusions we draw from the apparent contradictions between bond and equity market pricing, we are never proved right until the market agrees with our analysis and prices move accordingly. There are many other reasons to ascribe greater risk premiums to companies wrestling with higher input prices, slowing economic growth and stubborn inflation - not to mention political uncertainties and instability on both sides of the Atlantic. However, perhaps we should risk leaving the Tech party a year or two early rather than a day or two late.

About the author 

Jo Welman had a career in the City spanning 45 years and worked in a wide variety of financial sectors. After graduating from Exeter University in 1979 with a degree in economics, Jo spent ten years at Baring Asset Management where he managed a range of UK and US pension funds and unit trusts, investing across multiple sectors including bonds, international equities, commercial and residential property and private equity.

In 1989 Jo became Managing Director of merchant bank Rea Brothers’ institutional and private wealth investment management division. Over the following decade Jo launched a series of specialist investment trusts and funds in a variety of industry and property sectors, before forming a joint venture with reinsurance broker Benfields (now Aon Benfield) and raising one of the first limited liability corporate capital vehicles for the Lloyds insurance market in 1993. As part of his long-standing involvement in the insurance industry, Jo co-founded the Benfield Re-Insurance Investment Trust plc (Brit) in 1995. Following the sale of Rea to Close Brothers in 1999 Jo became Chairman of Brit Insurance Holdings Plc and in 2001, in partnership with Brit and Benfields, he co-founded specialist asset management firm, EPIC Investment Partners (EPIC).

Jo continues to provide corporate finance and investment advice to entrepreneurs and private investors. He sits on the board as a non-executive director of ARK Syndicate Underwriting.

“Feet up by the pool”

Jo does not receive any remuneration for his EPIC commentary. Instead, EPIC is pleased to promote the latest edition of his book “Feet up by the pool”.

Profits from sales of the book go to The Money Charity, a charity that shares Jo’s objective to help fill in some of the worrying gaps in the school curriculum. These omissions leave many young adults lacking in the financial awareness that they need to survive in a world where they will rely on their own savings if they are ever to stop working. Even if they earn the right to a full State Pension, today this amount hardly covers council tax and utility bills, and so they need to save and build up a sum of capital amounting to around twenty times their desired retirement income. A frightening number.

As Jo eloquently says, “If we can do our bit to raise awareness of the impending UK saving and pensions crisis, the exercise will have been worthwhile.”