How the Fed’s rate hikes spelled trouble for banks like SVB

Why bonds lose value when the Fed hikes interest rates and what that has to do with banks.

You know, at the root of all this banking turmoil — the runs on banks, the collapse, the potential reworking of how bank insurance works, the political fighting — is one seemingly simple economic phenomenon: When interest rates go up, bond values go down. That’s what’s got a bunch of these banks into trouble. 

But why is that? What does the Federal Reserve raising interest rates have to do with the value of bonds sitting in bank vaults?

OK, let’s say you buy a bond. And you know it’s a bond, so it gives you payments; they’re called coupons. 

Say you pay $1,000 for a 10-year bond, where you get paid 5%. These payments are locked in; they’re part of the bond. No matter what, you get $50 a year. 

But then, something happens. The Fed raises interest rates, and that pushes up interest rates all over the economy — including for new bonds, the ones printed just today.  

Let’s say these new bonds give you 10% now, or $100 a year. How do you feel about that old bond giving you just 5%? You’d rather have a better bond and you might just sell the original.

But here is the problem: “The price of the bond is determined by what other people are willing to pay,” said Eric Winograd, U.S. economist at AllianceBernstein. 

You might have paid $1,000 for it to get $50 a year. But who’s going to give you what you paid for it when there are better alternatives? Nobody, that’s who. 

“So the price of your 5% bond has to go down,” said Steve Laipply, who coheads bond ETFs for Blackrock. 

Now, your bond is still gonna crank out those $50 payments every year come hell or high water.

“The cash flows can’t change, but the price can,” Laipply said.

If someone buys your bond for less than its original value, you’re going to take a loss. That’s what happened to the banks that were forced to sell to cover withdrawals. 

But for the buyer, it’s just as if the bond had a higher return for them. They buy it for half price, but they’re still getting the same $50 payouts. For them, the return is just as good as a new bond.

So, that is why bond prices fall when interest rates go up: When interest rates rise on new bonds, the older lower yield bonds have to compensate by getting cheaper.

“And that’s what we saw all throughout all of last year,” said Marvin Loh, a senior strategist at State Street Global Markets. “Bond prices went down as interest rates were rising.”

And that’s where the banks got in trouble. They had invested in bonds, the value went down, some of them hadn’t covered their risk as banks usually do, and we got the mess we’re in now.