Week 29: Interest Rates, Venture Capital and High Yield Debt

Briefing: Following many decades of incredible success, venture capital investing is aggressively funding the next wave of innovative disrupters. The high yield rate, the rate that investors earn from buying “junk” rated companies, is the lowest it’s been since 2007, which signifies very low bankruptcy risk. Where should future interest rates settle now that the 10 year treasury rate is back down to the 1.25% range after a brief spike? Do these rate changes impact the pace or funding of innovation?

Tiger Global leading the venture capital pack

Originally known for their success investing in global public internet and technology companies, Tiger Global has dramatically increased their private venture capital activity over the past year. Tiger was the #1 venture capital investor by deal flow in the 2nd quarter averaging 1.3 deals per day. This has led to many complaints in the industry that Tiger is investing too quickly and without regard for valuation. What’s more important is that the next wave of innovators is getting the capital they need to create and push boundaries in robotics, cyber security and the digital revolution at large. There’s never been a better time to start a company now that there are billions set aside specifically for visionary risk taking innovators.

High yield rates are at 15 year lows

The other term for high yield bonds is “junk bonds”. The high yield rate refers to the return investors can expect to earn on an annual basis by owning the debt of companies that have some degree of bankruptcy risk. The current high yield spread is 3.15%, the lowest it’s been since 2007. The risk free rate (10 year treasury) is 1.25%. When you add those two rates together you get a measly 4.4%. In other words, investors earn just 4.4% annually by owning the debt of high bankruptcy risk companies.

Why might that be the case? One reason is there is too much capital chasing yields. Too many investors buying high yield debt for the higher yield will push the yield down. The other reason is that companies are less likely to fail today than they were even a few years ago. Easy access to financing through generous capital markets and the ever present potential to become an acquisition target has taken the risk of bankruptcy way down. Distressed investors who come in to buy when companies are at their worst have, “nowhere to go” due to a lack of distressed opportunities.

Bond market investors are highly sensitive to risk. Their investment upside is capped, so managing the downside risk is extremely important. Our takeaway here is that even the risk-averse bond market investors are saying there is very low distress or bankruptcy risk at the moment.

Starbucks has a free $1.6B loan from customers, with a 10% bonus.

Since we are on the topic of rates, Starbucks has an interesting lending relationship with its customers. Starbucks customers have approximately $1.6 billion in cash uploaded to Starbucks Stored Value Cards. This is essentially a $1.6B loan from customers to Starbucks. Roughly 10% of that balance is written off each year as “breakage”, unused expired balances. This effectively means that Starbucks is being paid a 10% annual interest rate to hold $1.6B for their customers. Starbucks has about $35 billion in borrowed assets on their balance sheet, so $1.6 billion is just 4% of the total. It’s not a bad deal for Starbucks by any means. You can imagine this same scenario is unfolding, perhaps to a lesser degree, with other companies that offer stored value cards.

Venture debt

One area where investors can earn an attractive yield is the venture debt sector. Startup founders who are raising capital often opt to raise venture debt instead. This debt does not dilute their ownership and does not set a new valuation as it’s not a traditional investment round. The interest rates on venture debt can be relatively high, 12-15%, which founders are willing to pay to avoid selling their shares. We wrote about this in detail back in April in our venture debt article. This form of debt is not available in public markets, but is available through private channels. Reach out if you would like to know more.

Yield on cash

One question we get frequently is, “how or where can I earn a yield on my cash?” Typically this cash balance functions as a general reserve, a future tax bill, or a future real estate transaction. We used to use Treasury Bills for cash management when the 1 year TBill yielded 2.5% in 2019 and 1.5% in 2020. Today that same 1 year TBill yields just .08%, hardly worth the trouble of setting it up. Instead of TBills, we’ve turned to using structured credit for certain cash balances.

In this case, the majority of the structured credit we use is comprised of agency mortgage-backed securities. In other words, the interest payments come from homeowners paying their mortgage on time and in full, and backed by the US Gov’t. This asset class tends to make people nervous due to a hangover from the 2008 crisis, however, the average US consumer today pays just 8% of their disposable income on debt service. That’s the lowest rate in 40 years.

The future of interest rates

Broadly speaking, it’s our view that there is too much cash seeking too few passive opportunities for low risk investments to produce an attractive return. So much of investing boils down to weighing risks, rewards and ranges of outcomes. Why should a risk free investment earn any return at all? The US has higher interest rates than most of the developed world. At 1.25% our 10 year treasury rate is much higher than the UK at 0.60%, Japan at 0.00%, or Germany at -0.40%.

Many worried investors pointed towards rising rates earlier in the year as a major risk factor. Over the course of 2021, the 10-year US treasury rate rose from 1.00%, to 1.75%, and back to 1.25%. These rate changes are not going to stop people from innovating within cloud technology, cybersecurity, robotics, semiconductors, battery technology, 5G, and so on. Those rate changes also won’t prevent venture capitalists like Tiger Global from investing billions into hundreds of promising new ventures.

In a world now dominated by fast-moving, disruptive emergent technologies, investors should focus on how they are allocated to take advantage of these major innovation-based changes.