Owen Walker, Ian Smith, Will Louch and Josephine Cumbo in London and Stephen Gandel, Antoine Gara and Harriet Clarfelt in New York Oct. 5, 2023
With prices plunging and yields at decade highs, these are the parts of the financial system that could come under strain.
A sell-off in global bond markets has pushed borrowing costs to their highest levels in a decade or more.
That means potentially heavy losses for banks, insurers, pension funds and asset managers that own trillions of dollars of sovereign and corporate debt after loading up in recent years.
Policymakers and investors are wary that the latest round of sharp moves could inflict severe damage on various parts of the financial system.
“We are watching this . . . very carefully to see if something breaks,” said Salman Ahmed, global head of macro at Fidelity International.
Paper losses on the most opaque part of US banks’ bond portfolios are now close to $400bn — an all-time high, and 10 per cent above the peak at the start of the year that caused the collapse of Silicon Valley Bank — according to Matthew Anderson, an analyst at bond data firm Trepp.
Most banks, and in particular the largest ones, will not have to sell and so will never realise those losses.
But the implosion of midsized US lender SVB in March refocused the minds of regulators and investors on the risks lurking in bank bond portfolios.
After receiving an avalanche of deposits from venture capital funds, SVB ramped up investment in a $120bn portfolio of highly rated government-backed securities. But when rates rose sharply last year, the value of the portfolio fell by $15bn, which was almost equal to the bank’s total capital, making it vulnerable to a wave of customers pulling their deposits.
At the same time, higher rates create more incentive for depositors to move their money, forcing banks to pay up to keep accounts — which ultimately hurts profits.
Shares of Western Alliance Bancorp, a Phoenix-based regional bank that like the former SVB caters to cash-challenged start-ups, have fallen 20 per cent since bond yields began their renewed rise in late August.
Among the big banks, Bank of America has been the worst performer. Shares of BofA — which at the end of the second quarter had nearly $110bn in unrealised losses, the most out of any bank in the US — hit a 52-week low on Wednesday of just below $26.
In all, the shares of the US’s largest banks, as measured by the KBW Nasdaq Bank index, have dropped an average of 8.5 per cent in the past month, erasing tens of billions of dollars from investors’ portfolios.
If paper losses on bond portfolios were realised they would have caused a 200 basis point hit to the common equity tier 1 ratios — a measure of financial strength — of the largest US lenders at the end of June, according to Stuart Graham, head of banks at Autonomous Research.
By comparison, the impact for European lenders fell from 100 bps to 80 bps in the first half of this year, partly in response to banks reducing their bond portfolios. But Graham said he expected the impact to be higher once banks reported their third-quarter numbers.
In response to SVB’s collapse, the European Central Bank carried out an industry-wide probe into eurozone bank exposure to rapidly rising interest rates to try to understand how risk could spread to other sectors.
The results, published in July, showed the 104 banks supervised by the ECB had combined net unrealised losses of €73bn in their bond portfolios in February. The analysis showed that those losses would increase by an additional €155bn in the worst-case scenario of the regulator’s bank stress tests.
“This should be regarded as an unlikely hypothetical outcome, as banks’ amortised-cost portfolios are designed to be held to maturity and . . . banks would typically turn to repo transactions and other mitigating actions before liquidating their bond positions,” the ECB said.
Life insurers are big holders of bonds, which they use to back liabilities such as pension obligations. Their share prices were hit hard following the collapse of SVB.
Insurers can often hold bonds to maturity, riding out market falls, while higher interest rates generally lift their solvency levels. But the concern is that a speedy rise in rates encourages customers to cash in long-term products, forcing insurers to sell bonds and other matching assets at a loss.
The worst-case scenario is that “policyholder behaviour changes such that the insurers become forced sellers”, said Douglas Baker, a director at Fitch Ratings.
European insurers including Generali reported a rise in so-called lapses at the start of the year in countries such as Italy and France, particularly in policies sold through banks, where customers are more likely to switch. Generali said the picture had improved in the second quarter.
The failure of Eurovita, a small Italian life insurer backed by UK private equity firm Cinven, was another sign of trouble. It was taken into special administration by the regulator this year after a build-up in unrealised losses due to rapidly rising rates, alongside what Italy’s central bank described as “inadequate risk management”, left it with a capital hole.
In general, higher yields on government debt are good news for UK pension funds because it improves their funding position. But a year ago, a sudden sell-off in gilts following then-prime minister Liz Truss’s “mini” Budget sparked a crisis in the pensions industry.
Many UK pension schemes use a strategy known as “liability-driven investment” which aims to hedge against moves in gilt yields and ensure long-term obligations to pensioners stay matched with long-term assets.
As investors fretted about the scale of proposed government borrowing and dumped gilts, yields on UK government debt soared.
That meant that the pension schemes’ hedging strategies had to be supported with more collateral.
To meet those collateral calls, pension funds cashed in their most liquid assets: gilts. That created a spiral where forced sales of gilts sent prices tumbling further and yields climbing higher — and then required the pension funds to stump up yet more collateral.
The speed and scale of the move in UK bond yields meant that many schemes could not find enough ready cash and had to sell less liquid assets, typically at a haircut.
The latest rise in bond yields has once again led to pension funds facing collateral calls. This time, consultants say the system is coping due to better controls on leverage and liquidity.
However, they warned that if bond yields continued to rise it could force some pension plans to dump less easily traded assets.
“Further yield rises might test some funds with tighter liquidity buffers,” said Simeon Willis, chief investment officer with XPS, a pension investment adviser.
“While there is no imminent possibility that the pension schemes are going to experience what they did a year ago from the rapid rise in gilt yields, what they are still exposed to is a longer-term persistent rise in yields chipping away at their asset base and leading them to the point where they need to further sell down illiquid assets, at a haircut.”
Corporate debt markets have also come under intensifying pressure from the sharp rise in government bond yields, which feeds through to companies’ borrowing costs.
The average yield on US junk bonds climbed above 9.3 per cent this week, up from less than 9 per cent at the end of September and 8.5 per cent a month earlier.
In turn, the premium that lowly rated borrowers pay above the US government to issue debt — a barometer of default risks — has also risen.
The moves have been more pronounced at the riskiest end of the credit spectrum, with the average spread on “triple C and lower” bonds expanding on Tuesday by its most in a day since March — when banking sector ructions stoked worries over tougher lending standards.
Many companies have also been able to hold off from refinancing debt, after taking advantage of ultra-low interest rates at the start of the coronavirus pandemic to borrow cheaply and push out maturities.
However, a flood of debt will come due in 2025-26 — and issuers of junk loans, which have floating interest rates, are already feeling the effects of US Federal Reserve tightening.
Rising yields “put more pressure on companies that are more levered or properties that are more levered”, said Greg Peters, co-chief investment officer of PGIM Fixed Income.
“You’re going to experience . . . a higher than typical default and distressed rate environment as these companies that really survived largely in part due to cheap financing start to unwind.”
The prospect of interest rates staying higher for longer is bad news for private equity on multiple fronts. Dealmaking had already dropped over the past 12 months as buyout firms struggled with the impact of rising borrowing costs.
“Private equity has for a long time been synonymous with ‘leveraged buyout’, so it goes without saying that the ‘leverage’ part becomes more expensive for current or prospective portfolio companies,” said Haakon Blakstad, chief commercial officer at Validus Risk Management.
The slowdown in the deal cycle has made it more difficult for firms to sell assets and return money to their investors. And the ability of companies to service their debt is also starting to appear more strained.
Researchers at Carlyle Group have warned that the rising cost of debt has dramatically lowered interest coverage ratios across the private equity universe, a metric that many lenders and rating agencies use as a gauge of whether companies can service their debts with operating profits.
Together with inflation and a slowing economy, that could lead to more buyout-backed companies running into trouble.
Rising long-term interest rates will also put pressure on private real estate valuations, where firms such as Blackstone and Brookfield have become some of the largest property owners globally.
Private real estate valuations have traditionally been done using benchmark rates of 10 years or longer, which up until recent months had risen far less than short-term rates. Were longer term rates to stay high for a prolonged period, it may force property owners to cut valuations anew just as trillions of dollars in loans are due to mature in the coming years.
Additional reporting by Mary McDougall in London
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