Are your bank bonds safe after the collapse of Silicon Valley Bank?

• SVB clients were spooked by the bond sale and proposed capital raising which led to a bank run

• The fall of SVB was ultimately because of poor risk management and its concentrated banking model

• The fallout led markets to rethink interest rates expectations as markets priced in lower rate hikes in the upcoming FOMC meet in March

• For bank bonds within our coverage, we maintain our recommendations due to the minimal spill-over effects

• We prefer AT1s with higher reset spreads due to lower extension risks

The collapse of Silicon Valley Bank (“SVB”) shook financial markets as it was the largest bank failure since 2008.  Before its collapse, SVB was the 16th-largest bank in the United States and was the largest bank by deposits in Silicon Valley. At one point, SVB was serving at nearly half of all venture-backed companies in the US.

What led to the fall of SVB?

Technology companies were facing a tough market environment and liquidity was drying up. SVB clients had to withdraw large amounts of cash in order to pay for rent and other operational costs. This led to SVB’s deposit base falling significantly in 2022.

In an attempt to reposition its balance sheet for the current high interest rate environment and improve its liquidity position from the client redemptions, SVB was forced to realise a USD 1.8 billion loss from selling its USD 21 billion from its bond portfolio, which was more than the annual net income the company made in 2022. According to a recent updated investor deck on 8 March, the sale of these bonds had a yield of 1.79% and a duration of 3.6 years, which is significantly lesser than the 10-Year US Treasury (“UST”) bonds which yields around 4% at that point in time.

Despite the sale, SVB still required additional capital and opted to raise an additional USD 2.25b via issuance of common equity and mandatory convertible preferred shares. This spooked its clients, who were worried about the financial stability of SVB. In a wave of panic, many clients pulled out their deposits, resulting in a bank run and its eventual collapse, forcing the Federal Deposit Insurance Corporation (“FDIC”) to step in.

(Related article: Everything you need to know about the collapse of Silicon Valley Bank)

Main reasons for the collapse

The fall of SVB was ultimately because of poor risk management and its unique banking model. SVB invested in UST in order to earn interest income from customer deposits. This is not unique to SVB and most major banks invests customer deposits into USTs. For SVB’s case, the failure to hedge its long-term USTs led the bank to book massive losses when they were required to sell their holdings to fund withdrawals. The loss in its books started the initial frenzy which eventually led to a bank run.

SVB has a unique banking model serving mainly VC firms and tech start-ups within the technology and life sciences sectors. SVB saw a large influx of cash during the pandemic as loose monetary policy allowed for many tech start-ups to grow tremendously. These companies opted to park their cash in SVB. This large corporate client base led to huge amounts of deposits being uninsured. By S&P estimates, ~94% of SVB’s domestic deposits were uninsured by the FDIC which only insures deposits up to USD 250k. When news first broke out about the loss incurred by the sale of USTs, these corporate clients will have higher incentive to induce a bank run as their deposits will not be insured by the FDIC.

Reaction in the fixed income markets

Markets saw volatility during the first trading session after SVB’s collapse over the weekend. There was a plunge in bond yields due to a rush into safe haven assets as investors feared the collapse of SVB may spill over to the rest of the banking sector. US Treasuries plunged with the 2Y UST yields falling by 60 basis points to 3.98% while 10Y UST yields fell 13 basis points to 3.57%.

Markets are also pricing in lower rate hikes in the upcoming FOMC meeting on 22 March 2023. The fallout of SVB have shifted market expectations. Goldman Sachs economists are now expecting no rate hikes in the upcoming FOMC meeting while Nomura is calling for a 25 bps rate cut. A stark contrast to the week prior where markets were pricing an implied Fed Funds Rate of 4.89% based on 22 Mar Fed Funds Futures.

Table 1: Adjustments to FOMC policy rate expectations after the collapse of SVB

The fallout led markets to rethink interest rates expectations. Higher interest rates led to bond prices falling (bond prices are inversely related to interest rates). The drop in bond prices caused massive bond losses from SVB’s holdings of long dated US Treasuries which eventually led to the bank run on SVB and its eventual collapse. All eyes are on the FOMC meeting on 22 March as markets are waiting to see how the US Federal Reserve will respond from the collapse of SVB. SVB’s failure may indicate that the Fed’s aggressive rate hike has a tighter grip on financial conditions and a recession may follow after.

We still expect the Fed to continue hiking rates as the fight to lower inflation is not over. It is likely the Fed will have smaller increments in rate hikes as they become cautious on the implications on financial stability from the pace of rate hikes. A rate hike will indicate that the Fed is still on course on their fight to tame inflation. We expect the front-end of the yield curve to be volatile as markets have been pricing a lower Fed Funds Rate and a 50 bps rate hike may cause short-term bond yields to surge.

If there are no rate hikes or a rate cut does occur, inflation expectations may increase as inflation is still far from the Fed’s target of 2%. This will cause the long-end of the yield curve to move upwards indicating inflation to stay higher for longer.

Will there be contagion effects to other major banks?

We think the spill over effects to other parts of the banking is minimal. Unlike SVB, most large banks have a diversified pool of depositors comprising of institutional and retail depositors. SVB had a large pool of institutional depositors and ~94% of deposits were uninsured. Retail depositors are stickier and have lower deposit amounts, lowering the risk of a bank run. Other banks may have 2nd degree or 3rd degree exposure to this event through loan exposure to VC firms or tech start-ups but we expect the impact to be minimal.

Table 2: EU banks have significant buffer over CET1 requirements

For bank bonds within our coverage, we maintain our recommendations due to the minimal spill-over effects. EU Banks within our coverage are large multinational banks with a diversified pool of depositors. These banks still remain well capitalised with large buffers over regulatory CET1 requirements (Table 2). While credit spreads may widen from the fallout of SVB, we do not think bank bonds from major EU banks are at risk for now.

Cautious on AT1 and Tier 2 bonds

US banks usually use preferred stock as a way to bolster their balance sheet. For the case of SVB, all of its preferred shares plunged to below 10 cents on the dollar during the fallout. Unlike AT1s, they do not have a write-down feature when CET1 ratio falls below a certain threshold. As it is subordinated to depositors and senior bondholders, it is unlikely that recovery rate for SVB’s preferred stock will be high.

We would also like to highlight our cautious outlook on Contingent Convertible (“CoCo”) bonds from banks. In our EU banking outlook, we highlighted higher extension risks in Additional Tier 1 (“AT1”) and Tier 2 (“T2”) bonds. Higher interest rates will result in calls being uneconomic for the bank, resulting in more non-call events. We prefer AT1s with higher reset spreads as it will lower extension risk as it will be more economical for the issuer to call back its AT1 bonds on its first call date.

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position and the analyst who produced this report holds a NIL position in the abovementioned securities.

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