Why Are Bonds Crashing- Two Contributing Factors to Rising Bond Yields
Why are bonds crashing?
Ticker symbol $TLT is a proxy for the performance of long term US Government bonds. $TLT is the iShares 20+ Year Treasury Bond ETF, it has now collapsed over 50% from its all time high in 2021 and at the time of writing it is now at the lowest price in its entire history since it launched in 2002. This is a global phenomenon, bonds in the UK, Germany, France, Japan have all seen a similar collapse in their long term bond markets. There are a few interpretations as to why this is happening. Like most things in markets, the answer is a culmination of many different things and usually not one thing exclusively. Two of the big drivers are inflation expectations and increased demand for capital.
TLDR: The short explanation as to why this is happening is that an interest rate is the price people pay for money. That money comes from the existing stock of collective savings globally. If there is more demand for money without an increase in supply that will cause interest rates to go up. Interest rates going up causes the value of bonds to go down. Large government deficits are competing with AI companies for trillions of dollars of savings over the next few years. With no additional supply of money, that pushes rates up all else equal.
Huge Demand for Capital
S&P Global forecasts $1.3T in spending on AI infrastructure in 2027. The “Hyperscalers” companies like Alphabet (Google), Amazon, Microsoft, Meta, Oracle, and SpaceX have a seemingly endless supply for their cloud computing services. These companies build large data centers across the country & run massive computers 24/7. AI companies like OpenAI (ChatGPT) and Anthropic (Claude) then buy the raw computing power produced by these data centers which they use to develop smarter and stronger AI models. The scale and returns on these investments are staggering.
This investment in AI is now becoming a considerable portion of the US economy and a substantial percentage of the growth we have experienced since 2023. Spending on computing infrastructure now represents 1.5% of the total economy. For reference spending on residential housing construction represents 3.6% of GDP. At 1.5% that's roughly the same as the amount of money spent on clothing & footwear in the US last year. From a rate of change perspective, if we look at how much of the economic growth has come from this spending, its about 36% of all economic growth is from AI related technology investments
All of that money going into investing in AI has to come from somewhere. Lets take Amazon for example, if Amazon plans on investing $220B next year into computer hardware, network hardware, concrete and drywall, they either have to have that money on hand or get that money from somebody else. A useful metric here is ROIC, which is return on invested capital. This metric is useful to look at a top down view, the return a company gets when they get money and deploy it into the business. Right now Amazon’s ROIC is around 22%, in an oversimplification, if they can raise funds at a lower interest rate than the return they are getting from investing that money, they should do that rather than spending their own money.
Investment dollars go where they are treated best, meaning they seek the highest return for the lowest risk. The Hyperscalers are going to the market and demanding a ton of capital, there is a lot of new demand for money. Interest rates can be seen as the price of money, and prices are set where supply meets demand. If there is a massive surge in the demand for money without a corresponding increase in the supply, the price i.e the interest rate will rise.
When the price of money keeps getting bid up and capital is harder to come by, thats usually when the Federal Reserve comes in to cut interest rates to effectively add money to the system through the banking sector. Given the clear signal that there is massive demand for new money, why hasn't the Federal Reserve shown up to provide more money to the economy?
Increasing Inflation Expectations
The conflict between Russia & Ukraine and also the U.S. & Iran have constrained global energy markets. Brent crude oil is now up 70% since the start of the year. About 20% of global oil supply flows through the Strait of Hormuz which has been shut off since the start of the conflict.
That only explains part of the issue, there is also the issue of widescale destruction of refining infrastructure. In the middle east, the International Energy Agency estimates that 3 million barrels a day worth of refining capacity is shut down. In Russia, refining throughput is down 30% year over year with 27 of 32 major refineries being targeted this year. Russia & the middle east are responsible for 20% of global oil refining. Its actually quite difficult to make up this lost capacity in the short term. New oil refining capacity can take years to come online, a recent example from Saudi Aramco shows a 9 year lag between greenlighting a large scale refinery and new refined products hitting the market.
So even if the war in Iran ends tomorrow and the Strait of Hormuz opens up, there is still a large negative supply shock to refined products that will persist for years to come. This is best illustrated in 2 different metrics, the Crack Spread Index and the price of diesel more narrowly. The Crack Spread index tells us the difference in price between a barrel of crude oil and the average output product for the average US refinery. Since the start of the war we have seen a 200% increase in Crack Spread. What that tells us is demand for refined products from US refiners has skyrocketed to make up the shortfall of global demand.
The downstream economic effects of this is rising gasoline & diesel prices for consumers. The entire supply chain of physical goods relies on diesel fuel. Everything you see in the grocery store was delivered to you from a machine that uses diesel either in the machinery to harvest crops or trucks that deliver it to stores. This has investors worried about a period of sustained higher inflation that will start hitting the US economy over the next 12 months. This restricts the Federal Reserve’s Ability to cut interest rates or stimulate the economy which will add fuel to the inflation fire.
Should You Buy Bonds
Obviously the answer depends on the type of investor you are & your personal risk tolerance and goals. We see major headwinds for bonds going forward, and our models are positioned away from longer term bonds which will get hurt the most if interest rates continue to rise. However, the risk return characteristics of bonds is materially better than it was just 12 months ago.
Hypothetical Numbers) For example, If we take October 22th 2025, which was a low point in the interest rate on a 30 year bond. If you purchased the bond on that day, let's say for $1000, you could lock in $42.50 in coupons for 30 years. Because of the rise in interest rates, that bond today would be worth $844.89 so a 15.51% drawdown inside of a year. You still get the same $42.50 in annual coupons for 30 years but between now and 30 years you experience volatility.
That same bond today, if you buy it for $1000 you can lock in $56.33 in annual coupons for 30 years. If the same change in interest rates happened today, from 5.63% to 4.42% that was a 1.21% increase in rates. If rates went from 5.63% + 1.21% -> 6.84%, an identical rise in interest rates would only lead to a 15% loss instead of a 15.51% loss. So from a risk reward perspective its more attractive than it was in the past 12 months and also a few years ago. We believe that bonds are more attractive today than they were, but we are not extending duration on our fixed income position today.
