Effect of interest rates on bond value and the ripple effect

Changes in value of financial assets, and bonds in particular, is the topic for this discussion. The US Federal Reserve Board (the Fed) has increased interest rates, specifically the federal funds rate (the rate banks charge other banks, usually for overnight loans).

Fed interest rate today 2022-present: The Fed’s latest moves in an era of soaring inflation

Rate hikes 2022-present

Meeting date

Rate change

Target range

March 15-16, 2022

+25 basis points

0.25-0.5 percent

May 3-4, 2022

+50 basis points

0.75-1 percent

June 14-15, 2022

+75 basis points

1.50-1.75 percent

July 26-27, 2022

+75 basis points

2.25-2.5 percent

Sept. 20-21, 2022

+75 basis points

3-3.25 percent

Nov. 1-2, 2022

+75 basis points

3.75-4 percent

Dec. 13-14, 2022

+50 basis points

4.25-4.5 percent

Jan. 31-Feb. 1, 2023

+25 basis points

4.5-4.75 percent

March 21-22, 2023

+25 basis points

4.75-5 percent

May 2-3, 2023

+25 basis points

5-5.25 percent

July 25-26, 2023

+25 basis points

5.25-5.5 percent

Source: Fed’s board of governors

As you can see from the data above, interest rates increased by 5% between March 2022 and July 2023. With these changes, there was a ripple effect felt across the economy. The value of bond portfolios held by banks as well as individual investors dropped, the “cost” of borrowing money increased across the board from car loans to mortgage loans as well as business loans.

For your discussion this week, I’d like for you to pick a sector or topic and discuss the impact of the interest rate increases. Below are examples of directions you could take:

Personally(Never put personal info in the post that you are uncomfortable with!! Speak in generalities if you prefer, the point is to apply the interest rate change impacts to your post.

How have the interest rate changes impacted on your purchase decisions – maybe it is to delay a major purchase (car or house maybe).

What about the buy vs. rent decision? There have been articles on how the relative economics have changed recently.

Have you modified investment allocations in your portfolio or IRA/401K investments?

Banking sector:

Pick a bank that has failed or was purchased by another bank because of problems with their bond portfolio or similar situation. What was the underlying problem at the bank? What was the outcome? Yes, a deeper discussion of SVB is acceptable here as long as you cite an additional outside credible source. The number of troubled banks is limited.

Corporate sector:

Pick a company that may have had to change their plans on raising funds because of required higher coupon rates. Maybe the company has experienced changes in its sales because consumers are holding off on spending.

Maybe discuss a firm that has had a hard time getting loans because of high rates.

There are a lot of different directions you can go with your post, but no matter what you choose (even personal) you MUST have at least one credible outside source (remember that Investopedia and Wikipedia are not considered reliable). As with any discussion, be sure to reread the grading rubric before posting.

Bottom line:

What aspect are you discussing? What changed, and why? How did decisions or outcomes change from what would have been expected without the interest rate increases? The “so what” is where I’m looking for. Go beyond “interest rates went up, bond prices went down”

https://www.marketplace.org/2023/03/21/rising-interest-rates-bond-values-banks/
From Marketplace (NPR)
How the Fed’s rate hikes spelled trouble for banks like SVB
Sabri Ben-Achour, Mar 21, 2023
Note from Dr. Kendall: This article provides a simple explanation to how bond prices are impacted by
interest rate changes.
You know, at the root of all this banking turmoil — the runs on banks, the collapse, the potential
reworking of how bank insurance works, the political fighting — is one seemingly simple economic
phenomenon: When interest rates go up, bond values go down. That’s what’s got a bunch of these banks
into trouble.
But why is that? What does the Federal Reserve raising interest rates have to do with the value of bonds
sitting in bank vaults?
OK, let’s say you buy a bond. And you know it’s a bond, so it gives you payments; they’re called coupons.
Say you pay $1,000 for a 10-year bond, where you get paid 5%. These payments are locked in; they’re
part of the bond. No matter what, you get $50 a year.
But then, something happens. The Fed raises interest rates, and that pushes up interest rates all over the
economy — including for new bonds, the ones printed just today.
Let’s say these new bonds give you 10% now, or $100 a year. How do you feel about that old bond giving
you just 5%? You’d rather have a better bond and you might just sell the original.
But here is the problem: “The price of the bond is determined by what other people are willing to pay,”
said Eric Winograd, U.S. economist at AllianceBernstein.
You might have paid $1,000 for it to get $50 a year. But who’s going to give you what you paid for it when
there are better alternatives? Nobody, that’s who.
“So the price of your 5% bond has to go down,” said Steve Laipply, who coheads bond ETFs for Blackrock.
Now, your bond is still gonna crank out those $50 payments every year come hell or high water.
“The cash flows can’t change, but the price can,” Laipply said.
You can choose to hold on to your bond, collect that low yield and receive the principal back at maturity.
But if you need to sell that bond in midstream, and someone buys your bond for less than its original
value, you’re going to take a loss. That’s what happened to the banks that were forced to sell to cover
withdrawals.
But for the buyer, it’s just as if the bond had a higher return for them. They buy it for half price, but
they’re still getting the same $50 payouts. For them, the return is just as good as a new bond.
So, that is why bond prices fall when interest rates go up: When interest rates rise on new bonds, the
older lower yield bonds have to compensate by getting cheaper.
“And that’s what we saw all throughout all of last year,” said Marvin Loh, a senior strategist at State
Street Global Markets. “Bond prices went down as interest rates were rising.”
And that’s where the banks got in trouble. They had invested in bonds, the value went down, some of
them hadn’t covered their risk as banks usually do, and we got the mess we’re in now.
Post by Camaro Bolton
Evergrande
For the latter part of the last 2 years since March 2022 interest rates have increased by 5% since March
2022 and July 2023. From the effects of such rate hikes, it has become more expensive for companies to
finance new growth projects and to also repay their debts since it has become more pricier because of
rate hikes. Not only has it had a hard result for companies in the U.S to borrow and repay their debts,
but also around the world. One of the companies that have had problems with pricing of their bonds
would be Evergrande in China. A Hong Kong court on Monday ordered Evergrande’s liquidation after
their creditors were not able to reach a deal on restructuring the company’s debts (Douglas, Joshua
2024).
Developers such as Evergrande gorged on cheap credit to finances loafs of constructions, that they used
to build towering apartment blocks on land sold to them by China’s local governments, which relied on
land sales to repay borrowing and finance spending. Then in 2020, as home sales started to slow
because of the pandemic and Beijing tightened property developers access to credit to tame the soaring
real estate market (Douglas, Joshua 2024). Having about $300 billion in liabilities, Evergrande stopped
paying its debts more than 2 years ago and has been negotiating restructuring its debt with creditors
since. The real estate market for years has been a driving engine for China’s economy, with residential
construction and related activity accounting for close to quarter of annual output. Scared of reinflating a
real estate bubble, officials have dripped federal stimulus into the sector, loosened home-buying
restrictions in certain cities, made cuts to interest rates and ensured banks are flush with cash to lend to
willing borrowers (Douglas, Joshua 2024).
References:
https://www.wsj.com/world/china/evergrande-is-finished-chinas-property-woes-arent-ea1be00f
post by Erica Barbour
Re: Effect of interest rates on bond value and the ripple effect
In early 2023, Silicon Valley and Signature Bank ended up failing and having their assets acquired by
other national banks. Following these banking failures, First Republic Bank collapsed in May in large part
due to shaken confidence in regional banks. One of the major contributing factors to these banks failures
was the rise in Federal Reserve interest rates (among many other factors). In the end, SVB’s assets were
auctioned off by the FDIC to First Citizens bank.
Federal Reserve interest rate hikes can significantly impact banks in various ways. One notable effect is
on the cost of borrowing. As the central bank raises interest rates, the cost of obtaining funds from the
Federal Reserve or other financial institutions tends to increase for banks. This elevated cost of
borrowing can squeeze banks’ profit margins, particularly if they have a substantial portfolio of loans
with fixed interest rates such as treasury bonds (Baldwin, 2023).
As the largest bank in Silicon Valley, SVB primarily served tech startups resulting in a concentration of
funds from a single sector. When rising inflation rates and economic challenges led these tech companies
to seek additional financing, they turned to withdraw their deposits from Silicon Valley Bank which
triggered a run on the bank. The bank, having invested a significant portion of its deposits in low-yield
treasury bonds, faced a liquidity crisis as it had to sell these bonds quickly at a loss to meet the sudden
demand for cash (Ramasastry, 2023).
Silicon Valley Bank served as a lesson to other regional – and national – banks. To help mitigate risk of
failure, banks should diversify their customer base to not rely too heavily upon one industry, especially
volatile industries like tech or start-ups. In terms of banks managing their own investment portfolios,
they should take care to not rely too heavily on one type of financial instrument. While Silicon Valley
Bank’s reliance on long-term government bonds was sensible in a stable economic environment, it failed
to adapt quickly when interest rates rose unexpectedly and had not diversified enough to recover cash
flow (Robertson, 2023).
Resources:
Baldwin, J. G. (2023, May 23). Impact of federal reserve interest rate changes.
Investopedia. https://www.investopedia.com/articles/investing/010616/impact-fed-interest-ratehike.asp
Ramasastry, A. (2023, May 24). The Silicon Valley Bank collapse explained. UW School of
Law. https://www.law.uw.edu/news-events/news/2023/svb-collapse
Robertson, S. (2023b, July). The collapse of Silicon Valley Bank: What happened and how your bank can
prevent a similar fate. Anaplan. https://www.anaplan.com/blog/silicon-valley-bank-what-happened-andhow-your-bank-can-prevent-a-similar-fate/