Understanding Interest Rates Impact

There's something counterintuitive about the impact of rising rates on bonds. The math behind the forecastability of bond returns is fascinating (…at least to a geek like me). Higher reinvestment rates offset interest rate shocks over time. If rates unexpectedly spike, the portfolio should go down immediately. However, we now expect to earn more yield than we did before the rate shock. If we ignore several less-important subtleties such as yield curve effects and the timing of the rate shock, this offset effect works no matter the size of the rate shock. It explains why historically, the initial yield-to-maturity has been a remarkably good predictor of forward return for bonds. The “sweet spot” of forecastability, or close enough to it, is when the investment horizon matches the portfolio's duration. Bond investors tend to worry about rising rates because of the short-term losses that occur when rate hikes aren’t already priced into the forward curve. However, contrary to conventional wisdom, this example illustrates how rising rates are good for bonds: higher rates mean higher reinvestment rates, and ultimately, higher expected returns. Adapted from Beyond Diversification, McGraw-Hill.

Rising Interest Rates & Credit Risk: What It Means for Expected Credit Loss (ECL) With interest rates climbing, the credit risk landscape is shifting. As borrowing costs rise, more businesses and consumers face financial strain, increasing the likelihood of defaults. That’s where Expected Credit Loss (ECL) analysis becomes even more critical: Expected Credit Loss = Probability of Default × Loss Given Default 🔹 Probability of Default (PD) → Higher interest rates can lead to increased defaults, especially for highly leveraged borrowers. 🔹 Loss Given Default (LGD) → Declining asset values (e.g., real estate or collateral) may reduce recovery rates, increasing potential losses. 💡 How Financial Institutions Are Adapting: ✅ Stress testing loan portfolios against rate hikes 📊 ✅ Adjusting risk models to reflect macroeconomic conditions 📉 ✅ Strengthening capital reserves to absorb potential losses 💰 The key to navigating this environment? A proactive credit risk analysis process that integrates real-time data and forward-looking risk models. As central banks continue adjusting policies, financial professionals must stay ahead of the curve. 📢 How is your organization managing credit risk in today’s high-rate environment? Let’s discuss in the comments! 👇 #CreditRisk #InterestRates #RiskManagement #Finance #CFO

𝗨𝘁𝗶𝗹𝗶𝘁𝘆 𝗦𝘁𝗼𝗰𝗸𝘀 𝗮𝗻𝗱 𝗧𝗵𝗲𝗶𝗿 𝗥𝗲𝗹𝗮𝘁𝗶𝗼𝗻𝘀𝗵𝗶𝗽 𝘁𝗼 𝗜𝗻𝘁𝗲𝗿𝗲𝘀𝘁 𝗥𝗮𝘁𝗲𝘀 Utility stocks represent companies providing essential services such as electricity, water, and natural gas. These stocks are often viewed as defensive investments due to their stable earnings and consistent dividends, appealing to income-focused investors. However, their performance is closely tied to fluctuations in interest rates. Below is an explanation of how utility stocks are impacted by rising and falling interest rates, supported by relevant financial theories. 𝗪𝗵𝗲𝗻 𝗜𝗻𝘁𝗲𝗿𝗲𝘀𝘁 𝗥𝗮𝘁𝗲𝘀 𝗙𝗮𝗹𝗹 1️⃣ Reduced Borrowing Costs Cheaper Debt Financing: Utility companies benefit from lower interest expenses on borrowed funds. OpCo debt is a passthrough to the customer, HoldCo debt (double leverage) is a hit to the shareholder. Improved Profit Margins: Reduced borrowing costs can boost net earnings, improving overall profitability. Growth and Dividends: Increased profits allow for greater investment in growth opportunities or higher dividend payouts, enhancing the stock's appeal. 2️⃣ Relative Attractiveness Compared to Bonds Declining Bond Yields: Falling interest rates lead to lower bond yields. Investor Shift to Equities: Income-focused investors may favor utility stocks for their higher dividend yields relative to bonds. Increased Demand for Utility Stocks: Higher demand often drives up utility stock prices. 3️⃣ Valuation Adjustments Discounted Cash Flow (DCF) Model Benefits: Lower interest rates decrease the discount rate, increasing the present value of future cash flows. Higher Stock Valuations: The perceived value of utility companies rises, leading to potential stock price appreciation. 𝗨𝗻𝗱𝗲𝗿𝗹𝘆𝗶𝗻𝗴 𝗧𝗵𝗲𝗼𝗿𝗶𝗲𝘀 1️⃣ Interest Rate Sensitivity Utility stocks are particularly sensitive to interest rate changes due to their high leverage and reliance on dividend yields in valuations. 2️⃣ Income Substitution Effect Investors often compare yields between bonds and dividend-paying stocks. Changes in interest rates influence these yield dynamics, affecting investment preferences. 3️⃣ Cost of Capital Interest rates are a key component of the weighted average cost of capital (WACC). Fluctuations in rates affect a company's cost of capital, impacting both investment decisions and valuations. ❓ 𝗪𝗵𝘆 𝗱𝗼 𝘆𝗼𝘂 𝗶𝗻𝘃𝗲𝘀𝘁 𝗶𝗻 𝘂𝘁𝗶𝗹𝗶𝘁𝘆 𝗦𝘁𝗼𝗰𝗸𝘀?

Important piece from Financial Times highlighting the impact of rising rates on Private Equity performance. TLDR: heightened interest rates mean GPs can no longer rely on abundant and cheap leverage and market driven multiple expansion (beta) to drive returns.   Its incumbent upon LPs to identify the PE GPs that drive alpha through differentiated and proven value creation strategies. https://lnkd.in/e6awZw3q GSAM cites a paper from the Institute for Private Capital that lays out the drivers of private equity returns since 2000 – see photo + link below: https://lnkd.in/eFSr4TXc Cheap and abundant leverage has played an important role in driving PE returns over the last 2+ decades before interest rates started rising in January 2022 (see photo). Why do rising rates erode the equity returns benefits of leverage? Because rising rates make debt more expensive, which ripples through the markets in multiple ways. A few examples. For existing PE portfolio companies: 1) Highly leveraged PE PortCos with existing floating rate debt suddenly have much higher interest rates, decreasing cash flows and debt service coverage ratios 2) Depletion of balance sheet cash to pay interest 3) Highly punitive debt refinancing terms / costs at maturity For new private equity deals: 1) Shortage of funding: banks have pulled back on LBO financing, prompting some private lenders to step in 2) Harder for GPs to underwrite deals to clear return hurdles without benefits of cheap leverage This is all a vicious cycle and has led to fewer new deals and PE exits (often to other PE firms)... Causing to the precipitous drop in PE deal volume (photo below). Beyond leverage, there is another critical impact of higher interest rates. This is the impact on theoretical company valuations and decrease in Multiples. The historical PE value creation chart (photo below) shows how "market multiple expansion" (e.g. beta) was a key source of post-GFC returns for many GPs. Why do rising rates impact multiples? Let’s first remember what a multiple represents. An EBITDA multiple represents the ratio of a company's Total Enterprise Value (“TEV”) to Annual EBITDA. So a $1,000 million TEV company with $100 million of EBITDA has a 10x EBITDA multiple. So where do interest rates fit in? The value of an asset or investment today is the present value of expected future cash flows. As interest rates rise, the discount rate rises, which decreases the total enterprise value. As TEV declines and EBITDA remains unchanged… then the EBITDA Multiple decreases. Now all of this is theoretical. Since rates started rising in Jan 2022, public markets started seeing valuations (thus multiples) adjust down... But private market valuations have held up. Not because valuations are unchanged by rising rates... but because deals are not getting done. Sellers don't want to lock in depressed returns. Buyers don't want to pay inflated prices. What's our lesson? Find the GPs who drive alpha.

👉 𝐖𝐡𝐲 𝐝𝐨 𝐰𝐞 𝐩𝐞𝐫𝐟𝐨𝐫𝐦 𝐩𝐚𝐫𝐚𝐥𝐥𝐞𝐥 𝐚𝐧𝐝 𝐧𝐨𝐧-𝐩𝐚𝐫𝐚𝐥𝐥𝐞𝐥 𝐲𝐢𝐞𝐥𝐝 𝐜𝐮𝐫𝐯𝐞 𝐬𝐜𝐞𝐧𝐚𝐫𝐢𝐨𝐬 𝐟𝐨𝐫 𝐁𝐨𝐧𝐝 𝐏𝐫𝐢𝐜𝐢𝐧𝐠? Bond prices are extremely sensitive to interest rate movements, but in the real world, rates don’t shift uniformly across all maturities. That's why we run multiple scenarios, not just one. 🔹 Parallel Shift: Every point on the yield curve moves up or down by the same amount. This helps us test the overall interest rate sensitivity of the bond portfolio — especially duration and convexity effects. 🔹 Non-Parallel Shift: Here we model more realistic rate movements like: → Steepening (short-term rates fall, long-term rise) → Flattening (short-term rates rise, long-term fall) → Butterfly shifts (short and long rates rise/fall, mid rates stay) 👉 These help us evaluate curve risk — the risk that different segments of the curve move in different directions or magnitudes. 💡 Regulators and internal risk teams care deeply about these because in practice, market shocks are rarely parallel. 👉 By performing both types of scenarios, we gain a more holistic understanding of how sensitive our bond positions are to various interest rate environments — essential for managing market risk and pricing models effectively. 👉 If you're pricing fixed income products and not stress-testing for these scenarios, you're missing a huge piece of the puzzle. #QuantFinance #FixedIncome #InterestRates #YieldCurve #RiskManagement #BondPricing #MarketRisk #FinancialModeling #StressTesting #Duration #Convexity

Cap Rate Expansion & Interest Rates 1. MacroEconomic Influences In a low-interest-rate environment, investors accept lower cap rates because the relative return is still attractive compared to other investment options. As interest rates rise, however, investors demand a higher return to compensate for the increased cost of borrowing and the correlated increase in risk. 2. Yield Sensitivity Real estate, as a long-term and capital-intensive investment, is particularly sensitive to changes in interest rates. When rates rise, the appeal of real estate diminishes unless the cap rates in correlation also increases widening the yield spread. 3. Risk Sensitivity Investors view higher interest rates as an indication of increased risk in the market. Consequently, they seek higher cap rates to justify the perceived additional risk associated with borrowing costs and potential fluctuations in property values. How to Navigate Cap Rate Expansion 1. Market Timing Consideration Understanding the cyclical nature of interest rates and their impact on cap rates is crucial for investors. Anticipating rate changes and market drivers allows for strategic decision-making. 2. Risk Management Cap rate expansion is not always negative. It can present opportunities for investors willing to take calculated risks. However, a well thought-out strategy is crucial to navigate potential risks within a rising interest rate environment. 3. Asset Class Diversification Diversifying real estate portfolios across different asset classes and geographic can mitigate the impact of cap rate expansion as each asset may be affected differently. #realestate #cre #finance #investing #multifamily #hospitality #industrial The CS Organization Carbon Ridge Capital Timothy Roman

The current environment of higher interest rates in the United States has recalibrated the financial landscape, particularly affecting the expectations of private equity and impact investors regarding the expected return on investment projects. This shift is markedly influencing the viability and attractiveness of sustainability / impact projects, which typically promise lower IRRs compared to more "traditional" investments. Despite their critical role in addressing environmental and social challenges, impact projects are finding it increasingly difficult to attract funding in a climate where the bar for expected returns has been raised. For private equity firms and impact investors, this presents a conundrum. On one hand, there's a growing recognition of the importance of sustainable investments for long-term value creation and risk mitigation. On the other, the financial mechanics driven by current market conditions compel a focus on projects with higher immediate returns. This tension is leading to a reduction in funding for projects essential for progress on critical sustainability goals. The situation underscores the need for innovative financing structures and incentives to bridge the gap between the financial requirements of investors and the funding needs of sustainability projects. Whether through government subsidies, public-private partnerships, or novel financial instruments, finding solutions to support these vital projects without compromising on required returns is essential. In conclusion, as higher interest rates shape investment strategies, the challenge for private equity and impact investors is to balance the quest for higher returns with the imperative to support sustainability projects. Addressing this challenge is crucial for ensuring that the momentum towards sustainable investment doesn't wane in the face of shifting economic conditions. #privateequity #privatemarkets #mergersandacquisitions #impactinvesting #sustainableinvesting #duediligence #agriculture #agribusiness #agtech

Do you really know how interest rates impact your real estate deals? Most investors focus on cap rates and cash flow...but miss how forward rates, yield curves, and swap rates silently shape their financing, returns, and timing. 1️⃣ Forward Rates = The Market’s Guess About the Future Think of this like Zillow predicting future home values — it’s a forecast, not a fact. → Helps you decide if you should lock in a long-term loan or wait → Smart investors plan based on where rates are headed, not just where they are 2️⃣Par Rate = The Fair Price of a Loan Just like you'd check comps before buying a house, the par rate shows the “fair” interest rate for debt. → If a loan’s interest rate is higher than the par rate, it might be overpriced → Use this to evaluate whether your financing is a good deal 3️⃣ Yield Curve = Market Vibes The shape of the curve reveals how the market feels about the future. → Upward slope = optimism, growth → Inverted = fear of recession — be cautious → Subtle changes = how the pros are adjusting risk 4️⃣Swap Rates = Lock In Your Costs This is like choosing a fixed-rate mortgage to protect cash flow. → Big players “swap” rates to manage funding costs → Miss the right swap rate? Your returns can take a hit Bottom Line: Understanding interest rates = smarter decisions on when to buy, refi, or raise capital. P.S. Want to learn and invest in commercial real estate? Join us in our exciting projects—whether as an active partner or a passive investor.

Day 21: Key Measures in Fixed-Income Analysis for Interest Rate Sensitivity In fixed-income analysis, investors and risk managers use several key measures to quantify a bond's or portfolio's sensitivity to changes in interest rates. These measures help understand the risk and behavior of fixed-income securities in response to interest rate fluctuations. 🏦 💲 🚀 1. Duration ⌛ ⏲️ Duration measures the sensitivity of a bond's price to changes in interest rates. It is expressed in years and represents the weighted average time to receive all cash flows (coupon and principal). Types of Duration: 1. Macaulay Duration:⌛ ⏲️ The weighted average time to receive cash flows. Useful for understanding a bond's time profile but less common in market risk analysis. 2. Modified Duration:⌛ ⏲️ Measures the percentage change in a bond's price for a 1% change in yield. Use Case: Assesses price sensitivity to small interest rate changes. 3. Effective Duration:⌛ ⏲️ Used for bonds with embedded options (e.g., callable bonds). Reflects price sensitivity to interest rate changes, accounting for option-like features. 2. Convexity 📊 ✈️ Convexity measures the curvature in the relationship between a bond's price and yield. It captures the second-order sensitivity of a bond's price to changes in interest rates. 3. Yield Measures Yield to Maturity (YTM): 🎢 🏦 The annualized rate of return earned if the bond is held to maturity. Helps in comparing bonds with different coupons and maturities. Current Yield: 🎢 🏦 Annual coupon payment divided by the current bond price. Yield Spread:🎢 🏦 The difference between the yields of two bonds is often used to measure credit or liquidity risk. Duration and convexity are foundational tools in fixed-income analysis. They provide insights into price sensitivity and help investors and risk managers assess and mitigate interest rate risk. By combining these metrics with other measures like PVBP and key rate duration, professionals can manage bond portfolios more effectively. Let me know if you'd like further calculations or examples! 💸 🗝️ 💲 #Quant #Finance #QuantitativeFinance #Derivatives #MarketRisk #RiskManagement #Trading #Risk #InterestRates #StressTesting

Critical that investors know how the past ~ 2 years of rising rates have impacted their portfolio: 🟠The expected contribution of your bonds to your future wealth is now more meaningful. Meaning all else equal, you can likely accomplish your same goals with less % in assets with higher uncertainty (e.g. stocks), and more % in assets with lower uncertainty (e.g. bonds). 🟠As you explore adding safer assets to accomplish the same goals (thus having more reliability on your future outcomes), the "center of gravity" (h/t Phil Huber, CFA, CFP®) of risk is the risk-free rate, which is the return of treasury bills. 3-month treasury bills currently yield 5.5%...they yielded 0.05% two years ago! This is the foundation of the contribution mentioned in the first bullet-point. It's why most people don't need to take as much risk anymore. 🟠Per a recent paper by AQR Capital Management, historically...investors have been rewarded for lowering their stock exposure when real rates (which account for inflation) have risen...such as the environment we are in now. Again, in accepting a higher expected contribution of bonds to our overall return, we don't likely need the same amount of stocks for the same goals anymore. 🟠And per this fantastic article by Laura Saunders in The Wall Street Journal, you can't just go chasing more yield for the hell of it. You need to be cognizant of the tax implications, which are impacted by the type of bonds you own, where you live, and how much income you make. So — your bond portfolio should likely have changed since two years ago. Full stop. "Set it and forget it" is always a great philosophy, but it's not always a great implementation strategy. Risk-free rates have gone from 0.05% to 5.5% — it's changed everything. But any evolution to your portfolio is NOT because you are timing the stock or bond markets. No one knows the future. You are just accepting that the contribution of your bond portfolio, which if thoughtfully designed can provide you high reliability around your future outcomes, has demonstrably increased. And make sure not to throw away any yield due to unnecessary taxes!