Many folks have written about what went wrong with SVB over the past few days, but few have explained it from a fixed income investing perspective. The core issue at the heart of SVB’s collapse is really asset liability duration mismatch. But what does that mean? How do we figure it out by looking at a balance sheet or disclosures? How is there risk in investing in Government-Backed Securities? This is what I hope to explain here.
When I was fresh out of college, I started my career as an interest rate trader on the trading desk at Morgan Stanley. I traded a variety of Treasuries, swaps, agency debentures, and both agency and non-agency mortgage back securities. In particular, this all happened through the great financial crisis in 2009 and the subsequent years. You could say I am intimately familiar with investing in a lot of the assets that were on SVB’s balance sheet (the same exact long duration mortgage-back securities and government treasuries)—all of which are very much now in the headlines.
What is interest rate risk?
Every bond carries two types of risks: credit risk and interest rate risk. Credit risk is basically the risk that the underlying issuer defaults on bond payments. The interesting thing about the bonds that SVB invested in is that they actually did not carry any credit risk because they were all government-guaranteed securities. But they did carry a lot of interest rate risk. By the way, this is why I was specifically a “rates trader,” the bonds I traded specifically only carried interest rate risk but not credit risk (that would make you a “credit trader”).
Interest rate risk means the value or the price of the fixed-income instrument changes depending on changes in the prevailing interest rate environment. Think of it like this: if you have a 10-year bond that pays a particular interest rate over the course of 10 years, the Net Present Value (NPV) calculation basically sums up the payments but then discounts it back to the present. Pretty straightforward, but when the market’s interest rate changes, the NPV of the interest and principal payments on a bond changes drastically.
Assessing interest rate risk
The longer the maturity of the bond, the more sensitive the NPV is to changes in interest rates.
Here's a simple rule of thumb to assess interest rate risk: If you have a 10-year zero coupon bond, its duration is literally 10 years. It means for every 1% change in interest rates, the value of the bond (the NPV of its cash flows) changes by 1% times its duration (10), which gets you 10%. Now, I mention zero coupon because for bonds with a positive coupon, the duration tends to contract a little bit. So for a 2% 10 year semi-annual pay plain vanilla bond, the duration is actually very close to 9 years, for simplicity’s sake.
In bond trading 101, when interest rates go up, the bond value goes down and vice versa. In this instance (for our 2% 10 year bond), as interest rates go up 1%, the value of these bonds would decline by 9%. And if rates go up by 4%, the value of the bonds would decline by 36%! This is nuts. (Yes we are ignoring the attenuating effects of convexity for now on duration risk, and non-plain vanilla bonds that are putable, callable, sinkers, and floaters for the purposes of this discussion.)
Unfortunately for SVB, a lot of their investments were made when interest rates were at all-time lows. They invested in a lot of longer-dated bonds, and so their interest rate risk was very very high. A lot of their bonds were actually also mortgages and so actually were negatively convex, which is even worse under some circumstances (but again, ignore that for now).
The issue with SVB’s interest rate risk
There’s nothing intrinsically wrong with investing in 10-year government-backed bonds at all. You will definitely get all of your money back, plus interest, at maturity. It is one of the safest instruments out there.
The issue with SVB is not that it invested in these bonds. All banks do this. The issue is that their liabilities didn’t match the same duration profile as the assets. If your liabilities are short-dated in nature, guess what: you might need short-dated liquidity, you can’t wait around for 10 years to get paid back by your bonds, so you should be investing in short-dated assets. The risk of selling bonds during the interim period when you are holding onto them creates mark-to-market risk.
It turns out that SVB’s liabilities were very short-dated in nature (due to depositors pulling funds out and companies needing more liquidity), but they were still investing in 10-year bonds.
SVB ultimately did need near-term liquidity, they did sell their long-duration bond holdings, and they did have to realize losses, which created a hole in their balance sheet.
Why didn’t SVB hedge out its interest rate risk?
That’s a very valid question. They should have. However, there are also some nuances, which I won't go into detail just yet (later forthcoming article) pertaining to technical accounting, in which hedging transactions can actually be extremely onerous on a bank’s P&L for Held To Maturity securities, and can create undesired volatility on the income statement. Actual Economic Risk vs Financial Reporting Risk will be the topic of a future article.