The Duration Bubble Has Burst!

Summary

• The interest rate is the price of time. When interest rates are high, so is the price of time, and vice-versa.
• After many years of low rates, the past year’s high rates have suddenly made time valuable again – bursting the duration bubble.
• Private equity (PE) is now an at-risk sector due to its long duration investments in technology companies.

Introduction

All of finance can be boiled down to time. How much is time worth to someone? What is needed to induce people to give up consumption today to invest for future gains and what is the price of time? It is the interest rate. This means that when interest rates are low, then the price of time is low. Suddenly, cashflows far in the future become more valuable.

It is no wonder that low rates tend to support loss-making companies; investors are willing to ignore the current losses for the promise of future gains. Investors are putting a low price on time. Such dynamics imply that investors all become long duration. After all, duration is the time needed to repay the loan or bond. You don’t mind being long duration if time is on your side.

Duration vs Credit Bubble

The period of low rates since the Global Financial Crisis (GFC) and turbo-charged in the immediate aftermath of the COVID-19 pandemic, can be characterised as a duration bubble, when viewed through this filter. Everyone stopped valuing time, instead rewarding gains in the far future. This included anything from unicorn start-ups, to crypto to private equity.

This stands in contrast to the 2000s and the GFC, which was a housing-linked credit bubble. Back then, new forms of leverage were created to invest in poor quality assets (sub-prime housing). Banks were at the heart of the leverage cycle. When they broke, the system collapsed.

In this way, the recent bank failures of Silicon Valley Bank (SVB) and Signature Bank in the US and UBS’s bailout of Credit Suisse in Europe are not a repeat of the global financial crisis. Rather, they reflect the bursting of the duration bubble. That is, higher rates from the past year have suddenly made time valuable again. Whether investors know it or not, they are all moving to reduce their duration.

It is no coincidence that crypto bank Silvergate preceded the SVB collapse. Nor that SVB’s deposit run was mainly venture capital-backed start-ups. The underlying cause was the collapse in the valuations of crypto and loss-making start-ups in an era when the present is worth much more than the future, thanks to higher rates.

Is Private Equity Next?

This framework allows us to understand where the risks in the system lie. Parts that benefited from low rates and expectations of distant future gains will suffer. In the end, these parts will be repriced lower. In some cases, this is immediate; in others it is delayed.

For US regional banks, accounting helped delay a reckoning. They were able to carry losses in their bond holdings due to ‘held-to-maturity’ (HTM) accounting. But a deposit run has brought scrutiny to these assets. Lucky for them they hold credit-worthy government bonds.

The biggest risks could lie in private equity (PE). They heavily invested in tech companies, which benefited from low rates and so were long duration. PE mark their own books, which could be masking future losses. Meanwhile, their underlying investors have made capital commitments. The hope is that PE firms can ride out any downturn.

Yet, when everyone starts to care about time, underlying investors may pull their commitments and investments may need to be liquidated, which reveals the true valuations. It happened suddenly for US regional banks; it could equally happen suddenly for PE firms. However, unlike banks, the Federal Reserve (Fed) is unlikely to accept their assets as collateral, given they are levered companies and not government bonds.

PE firms have dramatically outperformed the S&P500 over the past five years. That is the vulnerability to watch.

Conclusion

The era of low interest rates is over. We are now in a high rates environment, which is set to continue in the short and medium term. Time has become expensive again, and with it, long duration investments are increasingly unattractive.