SVB experienced a sudden collapse after customers withdrew their deposits in a rush over a period of two days. However, the underlying cause of its downfall dates back several years. Like many other banks, SVB invested billions into US government bonds during a time of low interest rates.
Unfortunately, this turned out to be a risky move as the Federal Reserve raised interest rates to control inflation. As interest rates increase, bond prices decline, which decreased the value of SVB's bond portfolio.
Last week, the portfolio yielded an average return of 1.79%, which is significantly lower than the 10-year Treasury yield of 3.9%, according to Reuters. Furthermore, the rise in borrowing costs due to the Fed's actions caused tech startups to allocate more of their cash towards debt repayment, leading to a shortage of new venture capital funding. As a result, companies had to withdraw their deposits held by SVB to finance their operations and growth.
Lessons from the SVB Collapse
Bonds are often considered a safe investment option for those who want to avoid the volatility of the stock market. They provide a steady stream of income in the form of interest payments and have a lower risk of losing money than stocks. However, not all bonds are created equal, and some can be riskier than others, especially when it comes to long-term bonds.
Long-term bonds are those with maturities of 10 years or more. While they can provide a higher yield than short-term bonds, they also come with additional risks. Here are some of the ways long-term bonds can become risky:
Interest rate risk
One of the biggest risks associated with long-term bonds is interest rate risk. As interest rates rise, the value of existing bonds decreases, as investors can purchase new bonds with higher yields. This can lead to a decline in the market value of long-term bonds, which can result in losses for investors who need to sell their bonds before maturity.
Inflation risk
Long-term bonds are also subject to inflation risk. Inflation can erode the purchasing power of the interest payments received from bonds, reducing the real return for investors. If inflation rises faster than expected, the bond’s yield may no longer provide adequate compensation for the loss in purchasing power.
Credit risk
Credit risk refers to the possibility that the issuer of the bond may default on its payment obligations. Long-term bonds issued by companies with lower credit ratings are more likely to default than bonds issued by companies with higher ratings. Investors who hold long-term bonds issued by companies with low credit ratings are exposed to a higher risk of default, which can result in significant losses.
Liquidity risk
Long-term bonds can be less liquid than short-term bonds. This means that it may be difficult to sell a long-term bond if an investor needs to do so before maturity. If there is a lack of demand for a particular bond, investors may have to sell at a lower price, which can result in a loss.
Call risk
Some long-term bonds are callable, which means that the issuer can redeem the bond before its maturity date. This can be a risk for investors if interest rates decline, as the issuer may call the bond and refinance it at a lower rate, leaving investors with a lower yield than they expected. This can result in a loss of income for investors.
It’s important to note that not all long-term bonds are risky, and the risks associated with them can vary depending on the issuer and the market conditions. Investors who are considering investing in long-term bonds should carefully evaluate the risks and rewards before making a decision. It’s also important to diversify one’s portfolio and not put all of one’s investment dollars into any one asset class or security.
Conclusion
While bonds are generally considered a safe investment option, long-term bonds can come with additional risks that investors should be aware of. Interest rate risk, inflation risk, credit risk, liquidity risk, and call risk are some of the risks associated with long-term bonds. Investors should carefully evaluate these risks before investing and diversify their portfolios to mitigate the potential risks.