I was reading this article in the Motley Fool about Silicon Valley Bank’s closure and in this paragraph was a bunch of terms that I couldn’t wrap my head around. But the thing that got me was: “bond values go down when interest rates go up.”
Can someone explain *why* bond values go down when interest goes up? And what crash course on economics I should take to get a handle on all this?
Excerpt from article:
>”This is where Silicon Valley Bank went wrong. It bought too many higher-yielding held-to-maturity (HTM) assets that were meant to be — as their classification suggests — held until they mature; this maturity could be as much 30 years into the future. The over-commitment to the wrong long-term assets subsequently prevented the bank from buying enough shorter-term, available-for-sale (AFS) bonds and debt instruments that (if necessary) could have been sold to fund customer withdrawals. Less than one-fourth of SVB’s securities backing customer deposits were of the available-for-sale variety, in fact. Aggravating the misstep was the purchase of fixed-income instruments that proved overly sensitive to rate hikes. Remember, bond values go down when interest rates go up.
>
>It was this unhealthy mix of assets that would eventually deal the death blow.”
In: 8
Lets say you have $1000 spare that you do not need now but need in ten years. So you go to the government and buy a $1000 bond that matures in 10 years with a 0.5% yearly interest. So in ten years you can take the bond to the government and get your $1000 back and an additional $50. Not much but at least your money is safe and gives some yield.
But now consider that right after you bought your bond the interest rates goes up to 1%. And it turns out that you actually needed those $1000 anyway. You can not go to the government to cash in your bond just yet, you need to wait ten years. So you go to an open market and offers to sell your bond to the highest bidder. The only problem you have is that the government is still issuing bonds but now at 1%. So if someone buys a bond from the government they will get an additional $100 in ten years instead of the $50 your bond yields. So nobody is willing to buy your bond for the full face value as the bonds the government issues yields more. You therefore end up having to sell your $1000 bond for only $950. You essentially lost $50 because the interest rate went up by 0.5%
If you buy a 5 year bond that yields 3% on maturity then interest rates go up so new 5 year bonds yield 5% on maturity, who would buy your old bonds worth 3%?
Just to clarify, bond value here means bond price and not the “intrinsic or inherent value of a bond”
If you buy a 5 year bond that yields 3% on maturity then interest rates go up so new 5 year bonds yield 5% on maturity, who would buy your old bonds worth 3%?
I think the typical layman confuses two topics with bonds. 1) What is the bond worth at maturity and 2) What is the bond worth today
I think lots of people get confused about number 1: You buy a bond for $100 that pays 5% interest and matures after 1 year. After 1 year you collect $105. This arrangement never changes regardless of interest rate hikes or macroeconomic trends or any complex issue you may have read about. Once you buy the bond, your “deal” is locked in.
The crux of the issue is scenario 2: What is the bond worth today. If you buy a bond for $100 that pays 5% interest, but a month later you decide to sell it it should be worth a tiny bit more than $100 (since its that much closer to collecting that $105). But! if rates have gone up to 10% now people can spend their $100 on these new bonds and get $110 in a year instead of $105… Well then if I can spend $100 and get $110 in a year I’m definitely not giving you $100 just to get $105. So if you want to sell your old bond you have to give me a discount to make it worth my while. So the CURRENT value of your bond goes down
I think the typical layman confuses two topics with bonds. 1) What is the bond worth at maturity and 2) What is the bond worth today
I think lots of people get confused about number 1: You buy a bond for $100 that pays 5% interest and matures after 1 year. After 1 year you collect $105. This arrangement never changes regardless of interest rate hikes or macroeconomic trends or any complex issue you may have read about. Once you buy the bond, your “deal” is locked in.
The crux of the issue is scenario 2: What is the bond worth today. If you buy a bond for $100 that pays 5% interest, but a month later you decide to sell it it should be worth a tiny bit more than $100 (since its that much closer to collecting that $105). But! if rates have gone up to 10% now people can spend their $100 on these new bonds and get $110 in a year instead of $105… Well then if I can spend $100 and get $110 in a year I’m definitely not giving you $100 just to get $105. So if you want to sell your old bond you have to give me a discount to make it worth my while. So the CURRENT value of your bond goes down
You bought a magic widget last year. It spits out $5 a year, and it cost you $100.
This year’s magic widgets are better, they still cost $100 but now spit out $10 a year.
Nobody will buy your old widget for $100. If you want to sell it, nobody wants to buy it for more than $50. Without such a discount, it’s not competitive with the new ones.
Last year, your situation was solid:
– Your main plan was to wait patiently for decades and watch your widgets slowly pay for themselves, then start giving you free money.
– Your backup plan, if you needed money, was to sell the widgets. You did the math, and calculated your widgets’ total value was more than you could ever possibly need.
This year, you have an enormous problem:
– You’re a bank, which means you owe money to many people who could ask for it at any time (“depositors”).
– Lots of them are asking for it; you suddenly need large amounts of money. Your main plan isn’t feasible anymore; you need money now and can’t wait.
– Selling widgets isn’t feasible either. Because your widgets are now only worth $50, selling them all won’t give you enough to repay everyone you owe.
You bought a magic widget last year. It spits out $5 a year, and it cost you $100.
This year’s magic widgets are better, they still cost $100 but now spit out $10 a year.
Nobody will buy your old widget for $100. If you want to sell it, nobody wants to buy it for more than $50. Without such a discount, it’s not competitive with the new ones.
Last year, your situation was solid:
– Your main plan was to wait patiently for decades and watch your widgets slowly pay for themselves, then start giving you free money.
– Your backup plan, if you needed money, was to sell the widgets. You did the math, and calculated your widgets’ total value was more than you could ever possibly need.
This year, you have an enormous problem:
– You’re a bank, which means you owe money to many people who could ask for it at any time (“depositors”).
– Lots of them are asking for it; you suddenly need large amounts of money. Your main plan isn’t feasible anymore; you need money now and can’t wait.
– Selling widgets isn’t feasible either. Because your widgets are now only worth $50, selling them all won’t give you enough to repay everyone you owe.
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