GInvestment is never without risk. Banks can go under, rob the burglar’s cash hiding place at night in the cellar and the mole’s garden. Share prices can plummet, as can the price of gold. Even real estate can become a financial nightmare.
However, it is considered particularly safe to lend your money to the American government. As the world’s leading currency, the dollar is fairly stable and the world’s leading economic power is highly indebted, but has sufficient financial strength to reliably pay off even large debts.
The Silicon Valley Bank has lent a large part of its assets to the American government. Put another large part in bonds backed by real estate. The solidity of the investment is beyond question. American government bonds are the benchmark for sound investments in the world. And yet the bank perished from this form of – as we often write so beautifully – as a safe investment.
To understand this, it is worth taking a closer look at the bond market. We illustrate it using the example of a flagship of the “safe” investment in Europe: A federal bond of the Federal Republic of Germany, which has the highest credit rating, issued in January 2022, at a time when zero and negative interest rates still prevailed. Finance Minister Christian Lindner (FDP) could afford to write a zero coupon on paper, with which he initially wanted to borrow four billion euros by 2032.
Nevertheless, investor demand was high. Deposits at the European Central Bank bore interest at minus 0.5 percent. The prospect of zero interest for Mr. Lindner is more attractive, especially since there is no question that the markets will be able to repay you reliably ten years later. Investors even paid 100.95 percent for the bond with security identification number 110258, which is to be redeemed in 2032 at a par value of 100. So they accepted a slight loss, which at 0.1 percent per year was still lower than the minus 0.5 percent at the ECB. For large sums of money there is hardly a safer form of storage than such government bonds.
The Silicon Valley Bank probably thought so too. But then came the war in Ukraine, commodity prices shot up and inflation with them. The central banks reacted by raising interest rates, and more so in such a short time than they had in decades. There is now an interest rate of 2.5 percent on deposits at the ECB, and the rate is likely to be increased to 3 percent on Thursday.
But what does something like this do to the bond market? In order for investors to continue to lend new money to the German state in this interest rate environment, Finance Minister Lindner had to pay a 1.7 percent coupon on a new ten-year government bond in July. In October it was already 2.1 percent for a term of seven years and in November 2.2 percent for a term of only two years. In such a phase, investors reallocate their money from the old bond, the one with the zero coupon. Why should they continue to lend their money for free when there is now such a good interest rate for the same risk with the same debtor. Since Bunds are traded on a daily basis, the course of the price shows how investors have abandoned the old bond and switched to the new one (see chart).
Actually no reason to worry
If you kept the old bonds because you bought them with a view to the end of the term in 2032, you don’t necessarily have to worry. There are no signs that the German state will not meet its repayment obligation of the agreed 100 percent. But not until 2032. Today the bond is quoted at around 80 percent.
Silicon Valley Bank may not have been sufficiently aware of this risk within the term. That would have been stupid. Or she took this risk with her eyes open without any protection, that would be negligent. To their misfortune, some investors have reclaimed the money they had made available to the bank at short notice. The bank had to sell the long-dated bonds at a very unfavorable time with high losses – money that was now missing to settle all the customers’ claims.
Anyone who invests in the bond market should be aware of these connections. He lends his money. That is why it is important to look at the creditworthiness of the debtor. The second, equally important look should be the runtime. Anyone who may need to be liquid in the short term but puts their money in long-term securities is taking on a maturity risk, which involves a higher risk of interest rate changes than with short-dated bonds. If the interest rate landscape changes, prices react accordingly and more so with long-dated bonds than with short-dated ones.
If it all comes together, the world will have another Lehman moment. Because the Silicon Valley Bank is far from the only bank that has put its money in such bonds, which have lost significantly in price. The government bond mentioned alone contains 31 billion euros. And it’s by no means the only paper in the deep decline. The insurers, as one of the largest bondholders in Germany, spoke of the high hidden burdens that they now have in their portfolio. As long as they don’t have to sell prematurely, there are no real losses. And those who are just getting started now can be happy and do so at significantly reduced rates. If 100 percent is repaid as planned in 2032, this currently brings a return of 2.5 percent per year. A very reasonable value. If only inflation weren’t running at 8 percent. But that brings us back to the topic of secure returns. There’s always a catch.