Explored: Interest Rates, Bond Yields & the Cost of Capital
A few months back, we wrote about the impact of rising rates on startup valuations. Since then we’ve received a ton of requests from founders asking about the impact of rising interest rates on bond yields and subsequently the overall cost of capital. More specifically, founders wanted to understand how rising Fed Rates, impact the cost of non-equity capital, such as venture debt, revenue based financing, and term loans. In this guide, we break down the various bond yield curves, the impact of interest rates and monetary policy on those yield curves, and ultimately how interest rates and bond yields affect the cost of capital. In summary, interest rates and bond yields are tangentially related, so as they increase, so does the cost of capital—let’s dive in!
What is a bond yield?
A bond yield is the rate of return investors receive for investing in bonds. Bond yields can be fixed or variable, depending on the type of bond. Fixed-rate bonds as the name implies, provide steady returns, while variable-rate bonds fluctuate based on the prevailing market conditions.
Bond yields are often used as a benchmark for other investments such as stocks and mutual funds. They are also used to measure the risk associated with a particular investment. Generally speaking, the higher the risk, the higher the yield.
What are interest rates?
Interest rates refer to the annual cost of a loan to a borrower, expressed as a percentage. The interest rate is exclusive of fees and other charges associated with the loan, therefore, they represent just one aspect of the overall cost of capital for startups seeking non-equity financing.
What is the yield curve?
The yield curve is a graphical representation of the relationship between bond yields and maturity dates. It is a line that plots the yields of bonds of different maturities, from the shortest to the longest. The yield curve is usually upward-sloping, meaning longer-term bonds have higher yields than shorter-term bonds. This is because investors require a higher return for holding a bond for a longer period. That said, the shape of the yield curve can vary depending on the prevailing economic conditions and monetary policy.
What are the different types or shapes of bond yield curves?
There are three main types of bond yield curves: flat, steep, and inverted. Each type of yield curve reflects different economic conditions, monetary policy, and perceived investment risk.
- Flat yield curves occur when the yields of bonds of different maturities are relatively similar. This type of yield curve is generally seen during periods of economic stability and low inflation.
- Steep yield curves occur when the yields of longer-term bonds are significantly higher than those of shorter-term bonds. This type of yield curve is generally seen during periods of economic growth and increasing inflation.
- Inverted yield curves occur when the yields of shorter-term bonds are higher than those of longer-term bonds. This type of yield curve is generally seen during periods of economic contraction and deflation.
What is a flatting yield curve look like and what does it mean?
Generally speaking, investors require higher returns for holding a bond for longer periods of time, as the implied risk is greater. When investors do not expect economic growth, inflation, or deflation in the near future, the demand and subsequent yield paid out for bonds of different maturities come closer to one another, ‘flattening’ the curve. A flattening yield curve is generally seen as a positive sign for investors, as it implies short-term stability.
What is a steeping yield curve look like and what does it mean?
When investors expect the economy to grow and inflation to increase in the near future, the yield curve steepens. A steeping yield curve means that the gap between short-term and long-term yield prices widens, as long-term bonds demand outweighs short-term bonds. Why? Well, if investors think the economy will continue to grow, and they believe that the return on long-term bonds has a better risk-reward ratio than short-term bonds, they buy more of them.
What is an inverted yield curve look like and what does it mean?
Inverted yield curves occur when the yield of short-term bonds exceeds that of longer-term bonds. They typically occur when investors believe that economic contraction and deflation are likely to come in the near future. Why? Well, naturally investors don’t like losing money, so when there is uncertainty in the market, they reallocate their capital away from long-term instruments to short-term instruments to hedge their risk, thereby driving up the demand and yield.
Note: eight out of the nine recessions the United States has experienced since 1955 have been preceded by an inverted yield curve, meaning investors' perceptions of the prevailing economic conditions were correct.
What is the relationship between bond yields and interest rates?
The relationship between bond yields and interest rates is an important one. As a reminder, bond yields represent the return investors receive on a bond, while interest rates refer to the cost of borrowing money. The relationship between bond yields and interest rates is complex and not always straightforward. There are several factors that can influence bond yields and interest rates, including the prevailing economic conditions, monetary policy, and perceived risk. That said, generally speaking, when interest rates rise, bond yields also rise, and vice versa.
How do prevailing economic conditions affect bond yields and interest rates?
At the start of an economic boom, prices are relatively stable and the demand for goods and services is low. As consumer demand picks up, prices naturally rise, causing inflation. Investors respond to this positive economic signal by shifting their funds from short-term to longer-term investments (steeping yield curve) which generate a higher return.
As prices continue to rise, consumer demand slows, equalizing the demand for short-and-long term bonds, thereby flattening the curve. Eventually, the demand for goods and services drops, bringing down prices (deflation) and investors re-allocate funds away from long-term assets to short-term assets, inverting the curve.
Note: this is a simplified overview of how the economy and demand for bonds vary. The main thing to take away is that the economy and demand for bonds are cyclical. During periods of expansion, the yield curve steepens, during periods of stability the yield curve flattens, and during periods of contraction, the yield curve inverts.
How does monetary policy affect the yield curve?
Monetary policy can have a significant effect on the shape of the yield curve. When central banks leverage expansionary monetary policy, they increase the money supply (and liquidity) in the economy. In tandem with the increased money supply, the Federal Reserve also typically reduces the Effective Federal Funds Rate, which in effect, represents the cost of borrowing money, and the return generated for storing cash with them. The increased supply of money combined with the drop in interest rates drives up the demand for goods, causing economic growth and inflation, leading to a steepening of the yield curve.
Conversely, when central banks use contractionary monetary policy, they decrease the money supply in the economy and also typically raise rates. This is to slow or cool down the economy, so it can stabilize, thereby flattening the curve.
Unfortunately, the central banks and the Federal Reserve often overestimate how much action is required, causing dramatic swings in the economy, as the US experienced first-hand during the boom of 2020-2021, the slowdown or stabilization of 2022, and the bust many experts predict will occur sometime between 2023-2024. For more on this check out the article we wrote in Forbes: Dreading the Fed.
How does investors’ perception of risk affect the yield curve?
During periods of economic expansion, investors’ perception of risk is low, and thus they are more comfortable parking their capital in long-term investments which generate higher returns, steepening the yield curve. As the economy slows uncertainty increases, and investors’ perception of risk becomes murky. The demand for long-and-short-term bonds equalizes, causing a flattening of the curve. As the economy contracts, investors fearing the worst, shift their capital to short-term vehicles, inverting the curve.
What is the relationship between the price of a bond and its yield?
The relationship between the price of a bond and its yield is an inverse one. In other words, when the price of a bond increases, its yield decreases; when the price of a bond decreases, its yield increases. So, going back to the yield curve scenarios:
- Steeping Yield Curve: The demand for long-term bonds exceeds the demand for short-term bonds, causing the price of long-term bonds to rise, and the price of short-term bonds to drop. At the same time, the yield of long-term bonds drops and the yield of short-term bonds rises.
- Flattening Yield Curve: The demand for long-term bonds and short-term bonds stabilizes, causing fluctuations in prices and yields for both.
- Inverted Yield Curve: The demand for short-term bonds exceeds the demand for long-term bonds, causing the price of short-term bonds to rise, and the price of long-term bonds to drop. At the same time, the yield of short-term bonds drops and the yield of long-term bonds rises.
How do bond yields impact the cost of capital?
Bond yields don’t directly impact the cost of capital, however, they do indirectly affect it. Why?
It has to do with the perceived risk/reward ratio by investors.
During periods of economic expansion, interest rates are low and the demand for long-term bonds is high which drives down the yield (return). With cash ‘cheap’ and returns in ‘ultra-safe’ investments low, investors, banks, and other financial institutions seek out higher returns through higher-risk vehicles, e.g. investing in or lending to startups. This increased supply of capital drives down the overall cost. As the supply of capital continues to build, competition among investors increases, resulting in hype, urgency, and fear of missing out (FOMO), further driving down the cost of capital.
The exact opposite occurs during periods of economic contraction. Interest rates rise, and capital dries up as investors flee high-risk assets, for ‘ultra-safe’ replacements. Competition for equity rounds become non-existent and the overall cost of capital rises. Though, it’s important to note that while the cost of equity capital rises exponentially, the cost of debt capital rises linearly. Meaning, that for most startups venture debt, revenue based financing, and term loans are actually better and more cost-effective in the long term. For a more in-depth look, check out the guide we wrote on startup valuations in a rising interest rate environment.
Final thoughts on interest rates, bond yields, and the cost of capital
We are currently entering a period of economic contraction, following one of the greatest venture capital funding crashes of all time. The Fed has raised rates nine times in just twelve short months, and late-stage startups have experienced their valuations cut by 50%+. Bond yields are at their highest level in more than a decade and so is the cost of capital. With the Fed expected to continue raising rates throughout 2023, bond yields will continue to rise and so will the cost of capital. Ultimately, as we have said and will continue to say, the strongest young companies will survive this downturn by scrapping growth-at-all-costs to focus on hardcore business fundamentals, including free cash flow and “positive unit economics”, and by seeking out alternative funding to minimize dilution during this ‘bust’.