The Bond Market Selloff is Showing up in Earnings Reports

0:01Tyler Crowe:The bond market is talking a lot louder. Motley Fool Hidden Gems Investing starts now.

0:11Tyler Crowe:Welcome to Motley Fool Hidden Gems Investing. I'm your host, Tyler Crowe. Today, I'm joined by longtime Fool contributors, Lou Whiteman and Matt Frankel. Earnings season is still happening. We're winding now. We're going to cover a couple earnings reports today from Klarna and Home Depot. But before we do, guys, the bond market is moving a lot more than it normally is, and it's moving in a direction that most people aren't a big fan of right now. Bond yields are the dividend yield, basically, of a bond or how much its value is rising, which basically means that people are not as willing to pay as much for bonds.

0:41Tyler Crowe:This isn't just happening in the U.S. either. Yields on government debt in many countries are hitting 20-year highs right about, you know, 2007 numbers, which when people hear that number 2007, a lot of alarm bells start to go off because we all remember what happened in 2008 through 2009. when we had high bond yields and the mortgage markets started to do things that we didn't want it to do. And of course, we got the Great Recession. Not saying that that is happening now, but we are seeing some of the highest yields we have seen in a long time. So guys, what is going on? Why is this all happening at once?

1:13Lou Whiteman:The last time the 30-year treasury was this high, like you said, Lehman Brothers was still one of the largest Wall Street firms. It's been a little while. If I'm a retiree and I need to shift some of my portfolio to fixed income, I'm loving this, but for most of us, it's not a great thing. This isn't the Fed's doing. The long-dated end of the yield curve, meaning the 20-year, 30-year treasuries, it's primarily market-driven. Remember in 2023, when the Fed rapidly raised interest rates to combat inflation and short-term interest rates spiked over 5%, the 30-year yield was actually lower then than it is now.

1:47Lou Whiteman:If investors expect rates to stay higher for longer, if there's added uncertainty, let's say a Fed chair who doesn't believe in forward guidance, just for one example. Or if debt issuance is unusually high, like a combination of a lot of government borrowing and a surge in corporate debt, it can push long-term interest rates higher. So you're right that this is global. This is not just the U.S. issue. Japan's 10-year is at its highest yield since 1996. UK's 30-year bond is approaching a 6 % yield. I could go on, but investors expect more compensation on top of inflation to hold long-term bonds because there is simply more supply to go around.

2:25Lou Whiteman:Matt's right. This is not the Fed's doing, but it's also kind of the Fed's doing, which is kind of the problem here. There are two things going on. First, the market is looking around the industrial world and seeing no end to budget deficits. It's happening in the U.S., it's happening in Europe. Higher debt means more risk, so investors are asking to be compensated for the added risk. That's how the bond market works. But secondly, and this is where the Fed comes in, there is this lingering worry about political independence of the Fed and the Fed's ability to act if needed to raise rates and combat inflation.

2:59Lou Whiteman:I hope those fears are overstated, but I think they are justified. And until the Fed proves otherwise, it is in the penalty box with investors. The credibility of the Fed is probably its best tool for keeping rates down or to at least tamper rate expectations. So to the extent that it is not credible right now or less credible than it was, that's a big thing driving the 30 year in the U.S. Around the world, there's country specific issues going on everywhere. But I don't remember, this is a global competition for funds. If the Fed is paying more, it forces competition. It forces everybody else to pay a little more because they all want to attract flows.

3:39Lou Whiteman:Couple that with what's going on in corporate style, which I think we'll get to next. There's just a lot of people battling for bond funds right now, and that is causing rates to go up to try and entice people to choose them.

3:54Tyler Crowe:For those of you who are Motley Fool members, maybe this is just the pitch to becoming a member. The three of us actually did a live Q &A yesterday where we were talking about this, too, with the supply and demand of debt in general is way up. And with that much extra supply, obviously the people who are buying it get to be a little bit more choosy. What do you call it? The buyer's market, if you will. and I feel like we have to ring a bell because we're going to bring in AI here because part of that as you were saying Lou the corporate issuance part is in large part because of all this AI data center spend and most directly the Magnificent Seven and a lot of these hyperscale companies we wouldn't normally bring them up in a conversation about debt and bond yields for years because they were these massive free cash flow businesses they didn't need debt they were sitting on massive piles of cash to the point where people were like why don't you guys do something with it like pay a dividend or something.

4:42But now we're at this point where CapEx for spending for AI is leading

4:45Tyler Crowe:to significant added debt, also using equity, and also using things both on and off the balance sheet to make a lot of this spending happen. So where do you think, as we think about AI build out and the corporate issuance sort of stuff, obviously it means that the cost of capital is going up. And where do you think this increase in capital will actually start to show up in this trajectory of AI build-out? Because we've watched the CapEx guidance for these Mac 7 companies, and they'll just raise guidance and just kind of brush their shoulders off. Like, it's fine. We'll just do it. So where do we actually see it start to bite?

5:26Lou Whiteman:Like you kind of just mentioned, it wasn't that long ago, like within the past couple of years, that most investors thought the AI build-out would be entirely funded by the cash flow these companies generate and the cash they had sitting on their balance sheet, like you said. But that's not happening. The numbers got too big. Hyperscale or CapEx is on pace to reach$750 billion this year, and estimates are calling for about$1.2 trillion next year. Trillion with a T. Debt funding is about one-third of that$750 billion this year, and it's likely to be an even greater a percentage of that higher number next year.

6:01Lou Whiteman:For example, Goldman Sachs is forecasting 35 % of that 1.2 trillion will be debt funded. And there's also that off balance sheet part of the discussion. Like you mentioned, the hyperscalers now have about$1.65 trillion of what we would call off balance sheet debt. This is things like lease commitments, which it's definitely a part of the AI revolution, JV structures they have on their balance sheet, things like that. That figure has 8x'd since 2022. So the debt from hyperscalers, and we kind of talked about this in the first section, competes with treasuries for investor dollars. And when you have a surplus of just long-term debt instruments, it can help push yields higher.

6:40Lou Whiteman:And we're already seeing that. We're seeing wider credit spreads on hyperscaler debt, just to name one example. So we're already seeing this show up. Tyler, it answered your question on when the increase will show up. It already has shown up. Alphabet just reported its first quarter of negative free cash flow since going public more than a decade ago. So the question, I think, isn't when it'll show up. The question is when it will stop. And the only answer we have is not soon. And one of the things hanging over the market is, is that we don't know the answer to that question. Arguably, the corporates have more of an ability to manage higher rates than a lot of these sovereigns do.

7:15Lou Whiteman:And I think that's reflected in rates. You know, I mean, look, they're not trading at U.S. standards, but they're trading pretty close, something has to give eventually. But at the same time, that eventually can be a long ways away. It's not a crisis right now. It's a crowding. I don't get the sense that bond buyers are anywhere near going on strike, so we can manage this. What we have to worry about is when that day comes where suddenly there is a bond buying strike, and what we do then, it's lingering out there. It's a threat. It's not there yet, but it's something we have to watch.

7:50Tyler Crowe:I think one of the interesting things that's going to be to follow is what changes the dynamic here, because we've seen this all happening worldwide, kind of all at once, and very curious what to see how this transitions and how it's able to move from this rising interest rate into something either flatlining or starting to go back down to levels that we've seen previously. But after the break, we're actually going to talk about two companies that have pretty direct exposure to what's happening in rising rates. We're going to start with Klarna coming up next.

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10:34Tyler Crowe:happening. Matt, what was in the earnings report? What was in it that actually sent the shares down 20 %? Now, we've seen a lot of 15, 20 % moves this year, this quarter specifically related to earnings. So is this just another one of those, yeah, big move with the earnings. We'll see what happens after a couple of days.

10:50Lou Whiteman:I feel like companies getting beaten down after mostly solid earnings has become a pretty recurring theme this quarter. But Klarna is actually pretty explainable here. For the most part, their quarter was excellent. 27 % year-over-year revenue growth, transaction margin dollars, which is a key metric of theirs, that was up 42%. They posted a net profit versus a net loss a year ago. Their merchant base, meaning the number of merchants that use Klarna, grew by 54%, and their credit quality actually improved. That was a big concern if you remember a few quarters ago. But like many companies, the real story here is a guidance cut, and it was a substantial one.

11:24Lou Whiteman:Klarna lowered its full-year revenue guidance. They blamed currency headwinds, And more significantly, they blamed reduced expectations from Germany, which is their number one market by volume. Plus they announced some big management changes. Their CFO and their chief marketing officer, both of whom have been with the company for a long time, are stepping down early next year. So forward-looking softness can crush a stock, even when the backward-looking numbers look great. And that's definitely what's happening here. Right. This is pretty simple. When you're trading at 20 times expected revenue, and we can, as Matt said, they move to a profit.

11:59Lou Whiteman:So we can give them a forward PE here, a little 85 or so times forward earnings. When you're trading at these levels, the market wants perfection. Yes, perhaps a sell-off seems odd with decent numbers, but we're in a situation where decent isn't good enough. And that's what we're seeing in the reaction today. I also have to imagine, too, when you're seeing softer guidance in conjunction with two of the people who are largely probably responsible for creating such guidance, the CFO and the chief marketing officer, all talking about transitioning.

12:32Tyler Crowe:You can definitely see why the market might be a little bit more spooked than normal. And look, Klarna is a financial services company. And I have to imagine that some of what we're talking about here in the bond market up in the first segment where we have rising interest rates in the private market, we're starting to see higher rates of default or write downs on private credit. And so there is creaks in the credit debit finance environment, which I think kind of just adds to the kind of piling on, I guess, if you will, for all of this. So considering this, like what we saw, softer guidance, what we saw with rising interest rates, cost of capital, because, you know, Klarna does have deposits, which does mean like you got to fight for that capital.

13:15Tyler Crowe:What can we expect from Klarna? Is this like the trend that we're going to see for a while now, or is there perhaps some sort of turnaround coming?

13:21Lou Whiteman:On one hand, Klarna funds its business, at least 90 % of its lending business with low cost deposits. So that's a nice competitive advantage. Klarna is a bank, unlike some of its competitors. but we're in a higher for longer rate environment and the longer we go the longer it seems like that's the case and that leads to a stretch consumer for a company that relies on payment volume and fees from people buying things that's definitely a problem to tie it into your global bond question from earlier their guidance reduction as i mentioned was mainly tied specifically to expected softer consumer spending in germany we mentioned european bond yields are at multi-decade highs in a lot of cases.

13:58Lou Whiteman:So of course, the effects of this are not Klarna specific. So this is nothing the company's doing wrong. And the company's credit metrics moved in the right direction, but it's definitely, you know, they're being affected by this environment. Right. This is macro concern, not Klarna's ability to fund itself, but on the subject of Klarna. And here's the thing. We never really know, fully know about a new fintech business, a new lending business until it has weathered a full cycle. Everything else is just modeling and the models tend to get things wrong. The market is focused on the near term. It's focused on things going wrong from here with the consumer.

14:35Lou Whiteman:I think that's appropriate, but as a long-term investor, I can't just whistle past this because we really don't know yet. There's a chance that Klarna proves itself out in a recession here and we find out, yes, their models work and this is a business that can weather an entire credit cycle. There's a chance that we'll learn that they can't. And as a long-term focused investor, I just need to accept that risk and accept that just we don't know. And there's no way to know until they go through it if you choose to buy in here. And back to my earlier point, when you were paying a high valuation for that uncertainty, I'm probably not surprised that there's at least some weakness or at least some lack of eagerness to jump in now.

15:18Lou Whiteman:and buy this.

15:19Tyler Crowe:We say the market doesn't love uncertainty, but it seems to like it when the, when it's a bull market, but when the bear market comes, all of a sudden everyone's afraid of uncertainty. But speaking of a company that has definitely weathered the cycles up and down for quite a while, we're going to talk about Home Depot's earnings.

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17:58Tyler Crowe:I guess you could say it's the continuing theme of the day where we're talking about companies that are very much influenced by what's happening in the macro environment. And I think Home Depot is definitely in that realm. They reported earnings today. Shares are only up about 0.4 % today. So it was kind of a little bit of a nothing burger reaction from Wall Street. Market's down. So maybe you could say, hey, they're up while the market's down. So putting a positive spin on it. Lou, what was in the report that might have people a little optimistic or is it maybe just a little bit of beating expectations, but the long-term trend kind of stays the same with Home Depot?

18:32Lou Whiteman:They held serve, period. They didn't break. They didn't do anything too impressive, but they held serve. They beat on the top and bottom line despite operating in what management called a frozen housing market. That's not great to hear, but look, again, they did okay. Looking under the hood, there's a lot going on. CompStore sales only up 1.7%, which looked a lot like price increases and not volume increases, so we would like to see volumes growing. Also, the company received$730 million in tariff-free funds in the quarter, which helped offset pressure on higher-than-planned fuel, higher-than-planned energy, and product input costs.

19:08Lou Whiteman:Management said it expects the higher costs to, quote, fully offset the tariff benefit. So the macro net is negative right now. They are basically saying that we can't just count on tariff-free funds to cover our higher costs forever. Home Depot has gone nowhere over the last five years. The stock is up just 5%. To be honest, that's pretty great. That's pretty amazing that it's held up as well as it has considering everything going on in the housing market. The company has lots of levers to pull. And I think investors kind of have baked in that the issues are macro, the issues aren't Home Depot specific, and that Home Depot will get through the cycle.

19:48Lou Whiteman:So I think it's pretty impressive how patient the market has been and tolerant of kind of underwhelming numbers, but at some point we would like to see acceleration here. I don't know when that's going to happen. Beating expectations in a frozen housing market is, it's certainly impressive and it really shows Home Depot's resilience compared to some other real estate plays, which we'll get to in a minute. The comp store sales growth, Lou mentioned it was 1.7%. That's not a knock your socks off number, but it does represent an acceleration over the previous quarter, which that in a frozen housing market is pretty nice.

20:19Lou Whiteman:The company also reported a higher average ticket, meaning like the average sale they're making went up significantly. And the big projects, which are often funded through home equity, like a full kitchen renovation, for example, those are still mostly on hold. That's what's been holding their business back really for the past four years. But the larger average ticket, it does show that smaller projects at least are making a pretty nice comeback here. So that's really nice to see too.

20:44Tyler Crowe:The only thing I would nitpick here too, though, is comps at 1.7. Yeah, it sounds good and it's accelerating, but it's also below inflation right now. So it's not exactly keeping up. Certainly we need to follow up on as we kind of watch the Home Depot story. And I want to tie this back to our theme on bond yields, the macro environment going on. Higher interest rates has basically kept that firm lid on housing, just like executives at Home Depot said, it's a frozen housing market. So does this make anything like, can you be there at the home improvement companies, Home Depot, Lowe's, or anything else, housing or real estate related, look attractive as kind of like that bottom of the cycle type of investment, even if we're not necessarily at the bottom of the cycle here.