Bond Watch: how bonds brought down Silicon Valley Bank

Sam Benstead breaks down the latest news affecting bond investors and income seekers.

Welcome to interactive investor’s ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.

Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.

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Here’s what you need to know this week.

SVB: why bonds were key to its collapse

Technology-focused bank Silicon Valley Bank (NASDAQ:SIVB) collapsed spectacularly last week, as its clients rushed to withdraw money in a classic “bank run” while SVB did not have enough cash on hand to meet withdrawals.

One of the reasons for its downfall was that it had invested customer deposits in long-dated US Treasury bonds. By loaning money to the US government for a long period, which is effectively what you are doing when you buy a long-dated bond, it was getting a higher return on its cash than buying short-dated bonds.

However, longer-dated bonds have collapsed in value in the past 18 months due to higher interest rates. If a bond pays 2%, but then interest rates shoot up from next to nothing to nearly 5%, then the low-yielding bond will naturally fall in price.

The crux is that SVB did not state on its balance sheet how the valuations of the bonds had changed following interest rate rises. Instead, the bonds were valued on the basis that they would be held to maturity – rather than sold. Therefore, it was not known how big the losses were until clients took money out.  

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When this happened, SVB was under pressure to raise money and realise the losses in parts of its bond portfolio. The result was that it did not have enough money to meet withdrawals and the US government had to step in to guarantee deposits for individuals and businesses that banked with SVB.

The collapse of SVB shows how rising interest rates can expose vulnerabilities in companies – but often only when it is too late. It’s common to hear that central banks will raise rates “until something breaks”. Well, something has broken, and there could be more financial issues brewing in other companies and business sectors.

Short bond yields fall on interest rate bets

Due to the collapse of SVB and the perception that “something is breaking”, traders are betting that interest rates in the US will not need to go as high, and may be about to fall. This is because cutting interest rates will relieve pressure on companies and the economy at a time when there is doubt about the stability of smaller US banks.

The yield on the US two-year Treasury bond, which often moves in line with short-term interest rate expectations, fell from around 4.8% to 4% over the past week. Bond investors bought these bonds, causing their yields to fall, because they expected the US central bank to dial down interest rate hikes, even though inflation is still high.

The question for central banks is now whether economic damage due to rising interest rates is worth it to quell inflation.

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Deutsche Bank strategist Jim Reid says: “I always thought that with inflation where it was, that central banks would keep hiking until they broke something, which was especially likely with the yield curve so inverted. Now they have broken something, is that enough for a pause? Much will depend on whether markets and contagion risk can calm quickly enough.”

Bonds shrug off the Budget

The prices of UK government bonds barely moved as chancellor Jeremy Hunt laid out his spending and tax plans this week.

In contrast to Kwasi Kwarteng’s budget last year, which prompted investors to dump gilts, much of Hunt’s policy decisions were leaked to the press in advance and did not have the same impact on government finances as Kwarteng’s extreme tax cuts.

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Investors believe that Hunt and prime minister Rishi Sunak are competent money managers and will conservatively manage government finances. Sunak’s intervention to find a buyer for SVB’s UK arm this week supports that view.