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Silicon Valley Bank – a lesson on bonds

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Those following the news will have noticed that three US banks went into a government-controlled bailout this month, Silicon Valley Bank and two rival banks. Silicon Valley Bank was relatively big being one of the top 20 largest US banks.

The Silicon Valley Bank was affected by holding too many long-term government bonds (fixed interest) that lost value as interest rates have increased over the past year together with an increase in withdrawal requests from its customers.

Does that ring a bell?

We have all been affected by losses on our bonds as interest rates rose over the past year. No one has been exempted.

We tried to limit the impact of falling bond values in our portfolios over the last two years as interest rates rose by reducing the term of our fixed interest sector and, where it was appropriate, reducing the exposure to fixed interest. It appears that Silicon Valley Bank didn’t have a strategy for rising interest rates.

What happened to Silicon Valley Bank is quite an enigma. Silicon Valley Bank had been too successful in recent years. Its customers, mainly tech startups, made a lot of money while interest rates were low, which they deposited in Silicon Valley Bank. So much money that Silicon Valley Bank didn’t know what to do with it and still make money for themselves (as banks are entitled to do). (Out of interest, three New Zealand companies had up to $100 million deposited with Silicon Valley Bank!)

There weren’t enough opportunities for Silicon Valley Bank to lend all that money out to new startups (only 40% of their total capital was loaned out). How were they going to make money on all those deposits? They had to pay their staff. They had to survive. They needed to show a profit on all that money the tech startups were giving them. So, in part, they bought long-term, rock-solid government bonds. 

Nothing could go wrong, right? If their customers needed their deposits back, they could sell their government bonds and they would have the cash to give customers their money back.

Investment 101 – 

  • When interest rates go up, the value of the bonds you already hold, falls.
  • The longer the term of the bond, the larger the fall in price.
  • Silicon Valley Bank held very long-term bonds at low interest rates. They were facing large unrealised losses on those investments after the big rise in interest rates.
  • Silicon Valley Bank had borrowed short-term and invested long-term. A mismatch in investment terms. Not good banking business.

Over the past year, many of the bank’s customers (tech startups) needed access to their money. They typically have large amounts of debt and their interest rates had been going up. They started withdrawing some of their deposits to pay interest bills. Silicon Valley Bank was not well diversified as it specialised in tech startups. Silicon Valley Bank needed to sell some of their bonds to raise cash to cover withdrawals.

In early March 2023, Moody’s, the rating agency, told Silicon Valley Bank they were going to review their credit rating downwards because of the reduced value of their bond investments. To try and maintain their credit rating, on Wednesday 8 March, the bank sold their bonds at a significant loss and announced a plan to raise additional capital by issuing new shares. Silicon Valley Bank deposit holders became alarmed and sought to withdraw their funds as quickly as possible. Fund managers, who owned shares in Silicon Valley Bank, started selling their shares causing a collapse in the share value. A typical ‘run on the bank’ was underway which led to the bank being bailed out by the US Federal Deposit Insurance Corporation (FDIC).

In order to restore confidence in America’s banking system, US public officials announced that the Federal Deposit Insurance Corporation would guarantee all deposits, including all uninsured deposits for those three banks. Shareholders are unlikely to get anything for their shares in those banks.

The rationale behind this strong response from the US government was to prevent any further bank runs and to help companies that deposited large sums with the failed banks to continue to meet their cash needs.

Technically this has not been a bailout by the US taxpayer as the Federal Deposit Insurance Corporation will cover the Silicon Valley Bank’s deposits and recoup those funds by increasing the levies it charges all US banks to fund their deposit insurance scheme. In reality, all US bank depositors will pay, in the long run.

For most investors with well diversified, non-active portfolios, the direct exposure to the Silicon Valley Bank in our share portfolios is minimal, between 0.03% and 0.04% depending on the underlying fund. That translates into about 3 – 4 cents for every $100 invested in the growth side of the portfolio. This small exposure shows the diversification benefits of being invested across thousands of businesses, many industries, and 50 or so countries.

There is quite a lot we can learn from this banking collapse:

  1. When interest rates rise we get temporary losses on longer term bonds.
  2. The longer the term of the bonds the larger the temporary falls when interest rates go up. (And vice versa, if interest rates fall, the longer-term bond values rise the most.)
  3. If you can wait until your bonds mature you will get your money back (so long as the institution hasn’t failed). That is why short-term bonds are less risky than long term bonds.
  4. All investors need to match their need for cash with the term of their investment portfolio. Hence the need for an emergency fund in case you need to take cash out of your portfolio when investment values are down.
  5. Diversify. It is always best to be diversified. Silicon Valley Bank wasn’t well diversified. When interest rates went up, it affected both them and their clients.
  6. Any bank can fail. They are just limited liability companies like any other business.