PART TWO—Secondary Trading
Well, Jane, if government bonds are so safe, why are they playing a role in the recent bank run at Silicon Valley Bank (SVB)?????
If you read my Banking Fable for Beginners, or ever watched It’s a Wonderful Life, then you’ll know a little bit about what causes a bank run. Briefly, commercial banks take deposits which can be withdrawn at any time. Banks then generate a return on those deposits by lending them out. But there is an immediate mismatch in timing, because the loans are long term—one, five, even thirty years for a mortgage—and the deposits are short term. Technically, that’s called an asset liability mismatch, and there’s a whole protocol for managing the risks associated with that. But at the end of the day, if depositors lose confidence in a bank and all rush to withdraw their money at the same time, the bank will collapse. No bank ever keeps all the deposits at the ready to be paid out.
That’s why the government has the Federal Deposit Insurance Corporation (FDIC)—insuring deposits up to $250,000–-to instill confidence in the banks. Anyone leaving more than that amount in a single bank, or a non-FDIC insured bank, is at risk of losing it in a bank run.
Ok, enough review. Back to bonds.
When the US government issues bonds, investors purchase them for a variety of reasons. Sometimes it’s for investment purposes, sometimes to use as collateral for other transactions, and sometimes just to keep their money safe until they decide what to do with it. US banking regulations treat government bonds very favorably from a risk perspective, which encourages banks to hold them to meet their mandatory capital requirements.
Sticking with SVB, after accounting for whatever loans they made, a portion of the remaining depositors’ money was invested in government bonds, a seemingly safe investment that they could easily sell when needed if depositors wanted to withdraw their money. In the meantime, they would earn interest on the bonds that exceeded what they were paying out to their depositors. Fair enough.
But then the Federal Reserve Bank began raising interest rates. Aggressively. And SVB didn’t adjust its strategy.
The thing about government bonds is they normally pay a fixed rate of interest. So a ten year bond purchased in March of 2020 paid less than 1%. But a new ten year bond issued in March of 2023 paid closer to 4%. Which means the 2020 bond is much less attractive—therefore worth less—than the new bonds which pay a higher interest rate.
So when SVB’s depositors came calling—including many tech firms with their own financial troubles arising from inflation and higher interest rates and who held balances at SVB well in excess of $250,000—SVB couldn’t sell the safe government bonds they were holding for as much as they had paid for them, let alone cover the asset liability mismatch.
US government bonds are safe in that at maturity, the government will give you 100% of your investment back. But in the interim, the value of the bonds is subject to market gyrations just like any other financial instrument, and bonds are highly interest rate sensitive. We’ve been in a low interest rate environment for over a decade. The sudden and rapid, but certainly not unexpected, rise of rates over the past twelve months to combat inflation has been hard for all bond holders (and issuers too for that matter, because it costs a lot more to borrow money these days.) And especially hard for those that didn’t plan ahead, as SVB and its customers discovered.
That interest rate sensitivity is one reason there is an active market in buying and selling bonds: technically called the secondary trading market.
And guess what’s happening in that market now? Everybody afraid of leaving their cash in banks is rushing to buy government bonds! Which is pushing up the value of those bonds, even as rising interest rates are pushing down the value of the bonds.
Why is that?
Since the interest rate and face value of the bonds is fixed at issuance—i.e. a ten year 2% $100 bond at issuance continues to have a $100 face value and pay 2% on that face value until maturity—the secondary trading market determines the value of the bond at any given time based on a variety of factors.
One factor is current interest rates vs. the interest rate set at the time of issuance. Think of it like a seesaw. In the center is the interest rate at issuance. On one end is current interest rates and the other end is market value. On the day of issuance, the seesaw is flat because the issuance interest rate and current rates are the same, which means the face value and the market value are also the same. When rates rise relative to the initial interest rate, the value of the bond goes down. When rates drop below the initial interest rate, the value of the bond goes up.
Another factor is the perceived safety of US bonds vs. other financial instruments. During periods of increased risk and uncertainty in the financial markets, investors prefer the safety of government bonds. Investors care less about how much interest they are earning and more about protecting their money. This is called a “flight to quality” and all that demand drives up the value of the bonds.
Another factor is the perceived liquidity of US bonds. Historically, many banks and broker dealers “made markets” in government bonds, meaning they were always ready to buy or sell when a bond holder wanted to trade. But after the financial crisis in 2008, new regulations were put in place to require higher levels of capital for the entities providing that service, so there are fewer of them now. That means the government bond market is not quite as liquid as it used to be. On a normal day, bonds trade fluidly but in times of stress, sometimes it can be difficult to execute a transaction swiftly because there are fewer entities willing to buy and sell.
Taken together, these factors essentially drive supply and demand, which, the same as in any other market—think toilet paper during Covid!—influences prices and availability.
To get a sense of the size of the market in government bonds, here are some statistics Year to Date as of February 2023 (source SIFMA.org):
Primary Issuance Market: The US Government issued $3.4 trillion of new debt—-up 13.4% from 2022—bringing the total outstanding to $24.3 trillion. (Total US debt is over $31 trillion—the $7 trillion difference represents intragovernmental borrowing including social security and military/civilian retirement funds that hold US treasury securities.)
Secondary Trading Market: Average daily trading volume was $650.1 billion—up 4.2% from 2022
So there you have it, Part Two of the Primer on Government Bonds.
Hope this was helpful!
