The Viewpoint: The rising cost of debt

The rate cycle may be approaching a turning point, yet the balance is fragile. For equity investors, the direction of bond yields, and the policy response they provoke, will be critical in determining whether current pressures ease or develop into a broader market disruption.

September saw borrowing costs rise rapidly across most major economies. Although shares and bonds are different types of investment, their performance is closely linked. Equity investors therefore need to understand developments in bond markets.

Bond investors are often seen as pessimists and equity investors as optimists. Bond prices typically rise when the economy weakens, whereas share prices tend to benefit from stronger growth. The two asset classes can therefore perform well under different economic conditions.

Bond investors are often seen as pessimists and equity investors as optimists.

Despite its negative reputation, debt can play a useful role. It allows people and businesses to bring forward spending against expected future income. A mortgage, for example, enables someone to buy a home and repay the cost over many years. Similarly, borrowing can help a company build a factory and create jobs before it generates the revenue needed to cover those costs, supporting investment and growth.

However, the cost of borrowing also affects the value of companies and their shares. Businesses usually fund themselves through a combination of debt and shareholder capital. When borrowing becomes more expensive, interest payments rise and profits fall. Higher rates also reduce the value investors place today on cash that a company may generate in future, lowering its overall valuation.

Rising borrowing costs create three main concerns. First, governments may struggle to meet higher interest payments without raising taxes or cutting spending. Second, more expensive credit can slow economic activity. Third, the consequences depend heavily on how the borrowed money was used.

All three concerns are relevant today. Governments borrowed more than they would have preferred during the Covid pandemic and the energy crisis that followed Russia’s invasion of Ukraine. Much of this debt supported economies through those shocks rather than financing new assets or jobs. Governments must therefore service the debt without receiving additional income from productive investment that can help meet the cost.

Consumers are also affected by higher interest rates. Existing borrowers may face larger mortgage payments, while others may delay taking out loans or making major purchases. Both effects reduce spending and slow the economy. At the same time, the expansion of artificial intelligence (AI) is increasingly being financed with debt, making the returns from AI investment more important to bond markets.

The expansion of artificial intelligence is increasingly being financed with debt, making the returns from AI investment more important to bond markets.

These pressures matter to equity investors because they can reduce company profits and valuations, constrain government finances, and weaken consumer spending and economic growth. With more AI investment also being funded by debt, bond market developments are likely to remain an important influence on equity markets.

The key question is whether borrowing costs are now high enough to cause a more serious disruption – and, if not, where that threshold lies. Rising interest costs are already straining government finances. This is most visible in France, but pressure is also evident in the UK, where another round of tax increases may follow in the October Budget.

The key question is whether borrowing costs are now high enough to cause a more serious disruption – and, if not, where that threshold llies.

The housing market is also under strain, with prices falling and transaction volumes low. More positively, there is no sign yet of a slowdown in AI-related investment, perhaps because demand for AI products and services remains strong enough to absorb higher financing costs.

From a risk perspective, governments appear most exposed. Unlike the public sector, companies are not highly indebted relative to their own history and do not face the same structural pressures from rising social care and defence spending. This marks a significant change from previous interest rate cycles, when corporate balance sheets were often the main source of vulnerability.

There are, however, benefits to higher interest rates. They can help control inflation and stabilise an overheating economy by making borrowing more expensive for consumers and businesses. The resulting slowdown in spending reduces demand-led pressure on the prices of goods, services and housing.

Higher rates also reward savers. Money held in higher-yielding savings accounts and government bonds can generate meaningful income, rather than the near-zero returns available when rates were low. This particularly benefits retirees and others focused on financial security, giving them a relatively low-risk way to earn a return without relying on the stock market.

For investors, the effects are becoming clearer. Interest rate-sensitive sectors such as housing are already in recession when measured by economic activity, while bank shares have come under pressure amid fears that higher rates could trigger a deterioration in credit quality. So far, however, the surge in AI-related capital investment has continued. Because AI-related companies carry substantial weight in equity indices, their strength has helped keep markets close to all-time highs.

There is a reasonable case that the interest rate adjustment cycle that began in 2022 is nearing its end. As the saying goes, the cure for high interest rates is high interest rates: the drag on economic activity may itself reduce expectations for future rates. Historically, rates at similar levels have also prompted a political or central bank response. This could take the form of a resolution to the Iran conflict or renewed bond purchases through quantitative easing. Even so, the situation remains finely balanced, and bond market developments could heavily influence the direction of equities in the coming weeks.

In conclusion, higher borrowing costs are now testing governments, households and interest rate-sensitive sectors. Corporate balance sheets remain comparatively resilient, and AI investment continues to support equity markets. The rate cycle may be approaching a turning point, yet the balance is fragile. For equity investors, the direction of bond yields, and the policy response they provoke, will be critical in determining whether current pressures ease or develop into a broader market disruption.

For professional investors only. This material is not suitable for a retail audience. Capital at risk. This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. Reference to any security is for information purposes only and should not be considered a recommendation to buy or sell.

The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change. Forward looking statements are subject to certain risks and uncertainties. Actual outcomes may be materially different from those expressed or implied.