We took our annual family trip to Park City recently, so I wrote my blogs ahead of time. Then Silicon Valley Bank failed. Now I am writing my fourth blog post on banks. So much for “be prepared.” I need to address the banking situation again because of incorrect information emanating from the media. Even though I do not watch television, I cannot escape television “experts” who explain things that are just wrong. These “experts” are usually nothing more than famous rich people, known hereafter as FRPs. Some of them have run for president. Yet, I have heard them explain that the California bank failed because they invested in T-bills. Others have said that the bank failed because of “safe” investments. It falls to me to explain how things actually work.
Usually, when FRPs use the term safe, what they mean is the ability of a bond issuer to repay principal and interest to bond owners. They do not mean how much we can sell a bond for on any particular day before maturity. United States Treasury bonds have an extraordinary ability to pay for the simple reason that it is the government that prints the money. However, the current market price of a T-bond depends upon prevailing interest rates and the time remaining until maturity. Let me illustrate this concept with an imaginary bond.
Suppose that the government issued a bond with a ten-year maturity. The bond is issued for $1,000 and pays 2% interest per year. At the end of ten years, the investor would have received $200 in interest and their initial $1,000 investment. Imagine that rates climb to 4%. An investor buying a new bond would receive $400 in interest over ten years. If the investor in the 2% bond wanted to sell his or her bond before maturity, he or she would need to discount the price so that a buyer would earn the equivalent of 4%. If we assume that five years passed, the difference in remaining interest between the 2% bond and the 4% bond would be $100, which would be the approximate discount necessary to sell the bond. Otherwise, an investor would just buy a new bond at 4%. After eight years, the interest difference between the two bonds would be $40 and that would be approximately how much an investor would need to reduce the price of his or her bond to sell it. The closer we are to maturity, the lower the discount and the lower the fluctuation in market value. At maturity, the T-bond investor will receive the full $1,000 face value. On the bright side, when interest rates fall, how much we can sell our bond for goes up, but only if we sell before maturity.
The FRP claim that Silicon Valley Bank lost money because they invested in T-bills is not true. By definition, a T-bill matures in less than one year. There is not enough remaining time for interest rates to have a significant impact on market price. Further, T-bills are among the most liquid investments in the world. If the bank had substantial funds in T-bills, they would have had no problem giving depositors their money back.
In last month’s newsletter, I wrote that “federal spending and pent-up demand are still stoking inflation, which means higher rates for longer. This is why we have kept the duration of our bond portfolios short.” Silicon Valley Bank did not do the same, which is a rookie mistake.