SVB Gives Bond Investors A Stark Lesson In Term Risk

(Bloomberg Opinion) -- It’s now clear that one reason Silicon Valley Bank failed is that it invested in riskier bonds than it could handle. It’s a “textbook case of mismanagement,” Federal Reserve Vice Chair for Supervision Michael Barr told Congress this week. That may be surprising to some people, given that the bonds in question included Treasuries and other government-backed loans, which are widely viewed as among the safest investments. It’s a useful lesson for individual investors about the risks lurking in bond portfolios.  

No investment is risk-free, but the closest thing is probably short-term loans to the US government, also known as Treasury bills. That’s because the US government has vast resources to pay back its loans, and investors get their money back quickly. The problem is that it’s hard to make money without taking risk. Since 1926, one-month T-bills have returned 3.2% a year, barely above the rate of inflation.

To make money, bond investors must generally take more risk, either by lending to less creditworthy borrowers than the US government, also known as credit risk, or by lending for longer periods, known as term risk or interest-rate risk. While there was little to no credit risk in SVB’s Treasuries and government-backed bonds, these bonds matured over years, not months, packing a meaningful amount of term risk.      

The danger with lending for longer is that when interest rates rise, bonds decline in value — and the longer a bond’s term, the greater the decline. It’s simple math: If you own a 10-year Treasury bond yielding 2%, which is roughly where yields were a year ago, and yields rise to 3.5%, which is where they are now, no one will want your lowly 2% bond unless you sell it at a deep discount. That’s precisely the scenario SVB faced when fleeing depositors demanded their cash.   

Last year was a master class in what happens to longer-term bonds when interest rates rise. One-month T-bills managed to eke out a return of 1.4% in 2022, despite the fact that short-term rates rose more than 4 percentage points. Longer-term Treasuries weren’t as fortunate. Five-year Treasuries lost 9.4% when five-year yields rose 2.5 percentage points, and 20-year Treasuries declined 26% when 20-year yields rose 2 percentage points.

Granted, last year was particularly brutal for Treasuries because interest rates rose so much so fast, but Treasuries are no strangers to declines. During the past nearly 100 years, 20-year Treasuries declined nearly a quarter of the time over rolling one-year periods counted monthly, and about 10% of the time those declines were greater than 5%. The term risk in Treasuries makes them riskier than their stellar reputation might suggest.    

The flip side is that investors have been compensated for term risk historically, although the premium has diminished with longer terms. Since 1926, five-year Treasuries have beaten one-month T-bills by 1.7 percentage points a year, a premium of about 34 basis points (0.34%) for each year of additional maturity. But 20-year Treasuries have beaten five-year Treasuries by only 0.3 percentage points annually, a premium of just two basis points a year. After a certain point, longer terms have resulted in worse risk-return trade-offs.

SVB undoubtedly knows all this, despite numerous claims that the bank’s executives were merely unsuspecting rubes. For one, term risk is bond investing 101. Also, it’s probably no coincidence that SVB’s bond portfolio reportedly had a duration of 3.6 years, which roughly corresponds to a maturity of five years — just the right spot for maximizing expected bond returns relative to term risk. SVB’s mismanagement was more likely knowing and calculated, if ultimately foolish. 

The decision to reach for additional yield was particularly brazen given where interest rates were at the time. No one can reliably say where rates will go, as SVB’s implosion demonstrates, but that doesn’t mean all moves are equally likely all the time. Over the past 150 years, the yield on 10-year Treasuries has been as high as 15% in 1981 and less than 1% in 2020. Needless to say, when interest rates are that close to zero, they have more room to move higher than lower, even if no one knows precisely when.

While term risk is walking-around knowledge for financial types, many investors may not be as familiar. Thankfully, funds that track the broad US bond market, which are popular and ubiquitous in retirement accounts, prevent investors from piling on more term risk than they can afford. SVB was a stark reminder of what happens when you do.   

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Nir Kaissar is a Bloomberg Opinion columnist covering markets. He is the founder of Unison Advisors, an asset management firm.

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