The sell-off in global bond markets has pushed borrowing costs to their highest levels in a decade or more.
That means banks, insurance companies, pension funds and asset managers that have held trillions of dollars in sovereign and corporate debt in recent years could suffer significant losses.
Policymakers and investors are concerned that the latest round of drastic measures could cause severe damage to various parts of the financial system.
“We’re watching this… very carefully to see if there’s anything wrong,” said Salman Ahmed, global head of macro at Fidelity International. “
Bank of America
Paper losses on the most opaque portion of U.S. bank debt portfolios are now approaching $400 billion, a record high and 10% higher than the peak that led to the collapse of Silicon Valley banks at the beginning of the year. Matthew Anderson, analyst at bond data firm Trepp.
Most banks, especially the largest ones, don’t have to sell and therefore never realize these losses.
However, the collapse of mid-sized U.S. bank SVB in March caused supervisory agencies and investors to refocus on the risks hidden in bank bond investment portfolios.
SVB stepped up investments in a $120 billion portfolio of highly rated government-backed securities after receiving a flood of deposits from venture capital funds. But when interest rates rose sharply last year, the value of the portfolio fell by $15 billion, nearly equal to the bank’s total capital, leaving it vulnerable to a wave of customers withdrawing their deposits.
At the same time, higher interest rates create more incentives for savers to move money, forcing banks to pay fees to keep accounts, ultimately hurting profits.
Western Alliance Bancorp is a Phoenix-based regional bank that, like the former Silicon Valley bank, serves cash-strapped startups. The bank’s shares have fallen 20% since bond yields began rising again in late August.
Among large banks, Bank of America performed the worst. Shares of Bank of America fell to a 52-week low on Wednesday, just under $26. At the end of the second quarter, the company had unrealized losses of nearly $110 billion, the largest loss among U.S. banks.
Overall, shares of the largest U.S. banks, as measured by the KBW Nasdaq Bank Index, have fallen an average of 8.5% over the past month, wiping tens of billions of dollars from investor portfolios.
european bank
If the bond portfolio experiences paper losses, it would cause the largest U.S. banks’ common equity tier 1 ratios, a measure of financial strength, to fall 200 basis points by the end of June, bank executive Stuart Graham said in an independent study.
By comparison, the impact on European banks fell from 100 basis points to 80 basis points in the first half of the year, in part because banks reduced their bond portfolios. But Graham said he expected the impact to be greater once banks release third-quarter data.
In response to the collapse of Silicon Valley banks, the European Central Bank launched an industry-wide inquiry into the risks euro zone banks face from rapidly rising interest rates, trying to understand how the risks spread to other sectors.
Results published in July showed that net unrealized losses on the bond portfolios of 104 banks supervised by the European Central Bank totaled 73 billion euros in February. The analysis shows that under the worst-case scenario of the regulator’s bank stress tests, these losses would add an additional 155 billion euros.
“This should be viewed as an unlikely hypothetical outcome because banks’ amortized cost portfolios are designed to be held to maturity… Banks typically turn to repurchase transactions and other mitigation measures before liquidating bond positions,” the European Central Bank said.
Insurance
Life insurance companies are big holders of bonds, which they use to back liabilities such as pension obligations. After SVB collapsed, their share price took a big hit.
Insurers can often ride out market declines by holding bonds until maturity, and higher interest rates often improve their solvency levels. But the concern is that rapid rises in interest rates could encourage customers to cash out longer-dated products, forcing insurers to sell bonds and other matching assets at a loss.
Douglas Baker, a director at Fitch Ratings, said the worst-case scenario is “a change in policyholder behavior and insurers being forced to sell”.
European insurers including Generali reported an increase in so-called errors at the start of the year in countries such as Italy and France, particularly for policies sold through banks, where customers were more likely to switch. Generali said the situation improved in the second quarter.
The failure of Eurovita, a small Italian life insurance company backed by British private equity firm Cinven, is another sign of trouble. The company was placed under special administration by regulators this year after mounting unrealized losses due to rapidly rising interest rates and what the Bank of Italy described as “inadequate risk management” left the company with a capital shortfall.
pension
Debt-driven investment strategies (which are sensitive to changes in bond yields) are at the heart of the explosion in the UK government bond market following the introduction of the UK’s “mini” budget in September 2022.
A year ago, when gilt yields soared, many corporate defined-income pension plans invested in LDI funds faced emergency collateral demands from investment managers.
Some plans struggled to provide cash to LDI managers quickly enough and were forced to sell illiquid assets, often at a discount.
The latest rise in bond yields has once again seen pension funds facing collateral demands from LDI managers. This time, advisers say, the system is coping thanks to tighter controls on leverage and liquidity.
However, they warned that if bond yields continue to rise, it could force some pension plans to sell less easily traded assets.
Simeon Willis, chief investment officer at pensions investment adviser XPS, said: “Further increases in yields may test some funds with tighter liquidity buffers.”
“While pension schemes are unlikely to experience the same situation as a year ago with the rapid rise in gilt yields, they still face the risk of a sustained rise in yields over the longer term, which would weaken their asset base and cause them to Further fire sales of non-current assets are needed.”
debt market
The sharp rise in government bond yields has also led to higher corporate borrowing costs, and corporate debt markets are also facing increasing pressure.
The average yield on U.S. junk bonds climbed above 9.3% this week, up from less than 9% at the end of September and 8.5% a month ago.
In turn, the premium low-rated borrowers pay over the U.S. government to issue debt — a barometer of default risk — has also risen.
The moves were more pronounced at the riskiest end of the credit spectrum, with average spreads on “3 C-rated and below” bonds widening on Tuesday to their highest daily level since March, when unrest in the banking sector fueled fears of tighter Concerns about lending standards.
Many companies have also been able to delay refinancing debt after taking advantage of ultra-low interest rates at the start of the coronavirus pandemic to borrow cheaply and delay maturities.
However, a large amount of debt is due to mature in 2025-26, and issuers of floating-rate junk loans are already feeling the impact of the Fed’s tightening policies.
Greg Peters, co-chief investment officer of fixed income at PGIM, said rising yields “put more pressure on companies that are more leveraged or real estate that is more leveraged.”
“You’re going to experience . . . higher than a typical default rate and a bad interest rate environment as these companies that do survive start to unravel largely due to cheap financing.”
private property rights
The prospect of interest rates remaining elevated for an extended period is bad news for private equity on multiple fronts. Deal volume has fallen over the past 12 months as buyout firms grapple with the impact of rising borrowing costs.
Haakon Blakstad, chief commercial officer at Validus Risk Management, said: “Private equity has long been synonymous with ‘leveraged buyouts’, so there’s no question that the ‘leveraged’ part becomes more expensive for current or future portfolio companies. “
The slowdown in the deal cycle makes it more difficult for companies to sell assets and return money to investors. The company’s ability to repay its debt also began to appear more strained.
Researchers at The Carlyle Group warned that rising debt costs have sharply reduced interest coverage ratios across the private equity world, a metric used by many lenders and ratings agencies to gauge whether companies can repay debt through operating profits.
Combined with inflation and a slowing economy, this could lead to more acquisition-backed companies struggling.
Rising long-term interest rates will also put pressure on private real estate valuations, with companies such as Blackstone Group and Brookfield Group becoming among the world’s largest real estate owners.
Private real estate valuations have traditionally been conducted using benchmark rates of 10 years or more, which until recent months have risen at much lower rates than short-term rates. If long-term interest rates remain high for an extended period of time, it could force property owners to lower their valuations again, just as trillions of dollars in loans will come due in the next few years.
Additional reporting by Mary McDougall in London
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