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The Bloomberg Barclays global aggregate bond index fell by 5.6% from the eve of the US presidential election to mid-December, hitting bondholders with mark-to-market losses of $2.4 trillion.
While investors in bank equity were celebrating the rise in interest rates that bank management teams have told them will bring higher earnings – bank share prices on both sides of the Atlantic rallied in lock step with rising bond yields – Euromoney could not help worrying where these losses may yet pop out.
Will investors in bond mutual funds and other fixed income products be the biggest losers, or will banks suffer too?
Analysts at Société Générale point out that not only had the market value of the benchmark bond index grown to close to $48 trillion at its peak last summer (2016), but the duration has nearly doubled since the global financial crisis, as rate repression encouraged governments and other issuers to ladle out long-dated bonds at record low yields. The average life of bonds in the global aggregate index extended from under nine years in 2009 to close to 13.5 years at the end of 2016.
There is no agreement on how fast or far rates will rise in 2017 in dollars and euros. There are many wise heads calling for 10-year US treasury rates to finish 2017 no higher than 2.7%, but plenty too calling for 3% and upwards.
Yet there can be only universal agreement that the size and structure of the bond market today makes it highly sensitive to changes in rates and that, if they go up far and fast, someone is going to end up in a world of pain.
If the Barclays analysts are right, investors in European bank equity may be able to read the bond market rout headlines in 2017 without resorting to the Prozac
Banks have been loading up on government bonds ever since the financial crisis as a core part of the liquidity buffers regulators forced them to build as a hedge against another sudden stop in market funding. Banks hope rising rates will boost net interest margins, earnings and retained capital, but could there yet be a cruel sting in the tail?
Ironically, what might save banks from the pain of taking heavy losses on these safety cushions is clinging on to them.
In a bond market rout, if they can avoid selling the very government bonds that were supposed to be easily realizable in an emergency, then banks might ride out any unrealized losses and dodge accounting any hit to their P&Ls.
Banks in Europe must hope therefore that regulators and policymakers find a safe path through the resolution of legacy NPLs that must now play out against the political uncertainty of elections in the Netherlands, Italy, Germany and France.
Barclays analysts point out that sovereign bonds typically account for 150% of the tangible equity base of European banks, although the figure is much higher (250% to 350%) for some large banks in the periphery of Europe where bad debt problems are at their worst, notably, Italy and Spain.
Barclays’ own analysis suggests that the average duration of many banks’ sovereign bond portfolios – and hence their exposure to capital loss from rising rates – is much less than for the global aggregate bond index. They put it at typically around four to five years and suggest that because banks have held these sovereign bonds for liquidity purposes rather than as a leveraged carry trade, hedges may have further shortened effective duration.
Euromoney can only nod in stout agreement and assume this must be so.
From September to early December last year, long-term rates had risen 40 basis points, with 10-year German government bond yields up from negative 10bp to a positive 30bp. Plenty of analysts see this rise continuing in 2017 up to around 70bp.
Unrealized losses
Hold on a minute, though. Even if banks can avoid accounting losses on sovereign bond holdings through the P&L, unrealized losses will still hit their book values. What will that do to their share prices?
Barclays suggests that in aggregate for the European banking sector, the unhedged book value erosion from September to December from falling government bond prices was around 3%, and that while a few banks in the periphery might appear to have exposure closer to a 7% to 9% erosion of book value, these banks are more likely to have hedged.
If the Barclays analysts are right, investors in European bank equity may be able to read the bond market rout headlines in 2017 without resorting to the Prozac.
Sadly, though, they should not rush to break open the celebratory Prosecco either.
Barclays points out that while investors have been hoping for a steep yield curve – and 12-month Euribor ground lower even as longer-term rates rose last year – this may delay the benefit to banks from any re-pricing of floating rate mortgage loan books that price off Euribor. While fixed-rate mortgages do price off the longer end of the curve, it takes several years for these loans to roll off and re-price at higher rates.