The Impact of the Fed's Interest Rate Increases on Banks such as SVB.
The increasing interest rates on bonds caused difficulties for Silicon Valley Bank and other financial organizations. This was reported by Patrick T. Fallon through his image on AFP/Getty Images.
Did you know that the main cause of the current banking chaos, such as sudden bank closures, economic downfall, reconsideration of bank insurance regulations, and political conflicts, can be traced back to one basic economic principle? It all boils down to the fact that when interest rates rise, the value of bonds decreases. This is precisely what has caused problems for several banks.
However, one may wonder about the correlation between the increase in interest rates by the Federal Reserve and the worth of bonds kept in bank safes.
Imagine you purchase a bond and are aware that it provides you with payouts in the form of coupons. Essentially, a bond is something that pays you regular amounts of money.
If you invest in a bond for 10 years with a purchase price of $1,000 and a 5% interest rate, you will receive $50 annually. This amount is guaranteed, meaning it is fixed and will not change regardless of the economic situation.
Suddenly, a change occurs. The Federal Reserve decides to increase interest rates, which results in a rise in interest rates throughout the entire economy. This also applies to freshly issued bonds, which experience higher interest rates.
Imagine that these freshly issued bonds currently offer you a 10% return, which means you would earn $100 annually. How would you react to your old bond yielding only 5%? Likely, you would prefer a more lucrative bond and might consider selling the initial one.
However, there exists an issue: Eric Winograd, a US economist at AllianceBernstein, has stated that the value of the bond is decided based on the amount that other individuals are willing and able to pay for it.
You may have spent $1,000 on it in order to receive a yearly return of $50. However, if there are more superior options available, there is no guarantee that you will be able to sell it for the same amount you paid. There will be no takers for it.
According to Steve Laipply, one of the leaders of bond ETFs at Blackrock, the value of your bond with a 5% interest rate must decrease.
Regardless of any circumstances, your bond will continue to generate annual payments of $50 without fail.
According to Laipply, the monetary inflows and outflows are fixed, however, the cost can be modified.
You have the option to retain your bond, gather the meager interest, and receive the full amount at the end of the term. However, if you decide to sell the bond before maturity, and someone agrees to buy it for a lower price than its initial worth, you will experience a decrease in value - this is what occurred with the banks that were compelled to sell in order to accommodate withdrawals.
However, from the perspective of the purchaser, it appears that the bond offers a higher return. They purchase it at a reduced price of 50%, but they still receive the same $50 payments. Thus, the purchaser's return is comparable to that of a brand new bond.
Therefore, this is the reason why bond values decrease when interest rates increase: As interest rates climb for newly issued bonds, the previously issued bonds with lower yields must decrease in price to make up for it.
Marvin Loh, a top analyst at State Street Global Markets, stated that we witnessed this trend throughout the entirety of last year. As interest rates increased, bond prices decreased.
This is where the banks encountered problems. They had put their money into bonds, which decreased in value. A few of them hadn't taken precautions to safeguard their finances as banks typically do, leading to the current predicament.
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