Goldman Sachs braces for bond market blow up
By Stephen Gandel, senior editor January 30, 2013: 1:35 PM ET
The bank cuts its interest rate exposure after warnings from CEO Lloyd Blankfein and COO Gary Cohn.
FORTUNE — Goldman Sachs is growing more nervous about the bond bubble.
In the past year, the investment bank has dramatically cut the amount of money it could lose on any given day if interest rates were to rise, which would cause bond prices to fall. The bank has also upped its own borrowing in order to lock in low interest rates.
The moves mirror cautious statements recently made about the bond market by Goldman’s two top executives. Last week, at the World Economic Forum in Davos, COO Gary Cohn, who is the firm’s No. 2 executive, warned that many banks and investors might not be prepared for the possibility of a “significant repricing” in the bond market. Cohn told Bloomberg, “At some point, interest rates will go higher again, and all of the money that has piled into fixed income over the past three years, some of it will come out.” Cohn, perhaps tellingly, noted that a bond crash would be “interesting” for Goldman.
In December, Goldman’s CEO Lloyd Blankfein said at a conference sponsored by New York Times that the risk of a bond market crash was growing and that investors appeared unprepared. What’s more, Blankfein said Goldman was advising clients to increase their borrowing to take advantage of low rates.
Goldman (GS) is taking its own advice. This month alone, Goldman has borrowed $8 billion from the bond market, including a three-part $6 billion debt offering, which was the firm’s largest ever. Some of that is refinancing. But the borrowing is up from $5.2 billion in January a year ago. And Goldman has been swapping out some of its 3-year bonds for debt that it won’t have to pay back until 2023.
The moves are reminiscent of those Goldman took in 2006 and 2007 in the run-up to the housing bust. The firm reportedly bet against mortgage bonds so that it could profit as the price of housing debt collapsed. After initially touting the bet to investors, Goldman backed off claims that it had profited from the housing bust, calling the firm’s trades merely hedges.
It’s not clear whether, or how, Goldman has made a similar bet against interest rates. A recent report from Bloomberg said Goldman had set up a secretive division that has placed $1 billion of the firm’s own money on bets on stocks and bonds, sidestepping a proposed ban on such activities. A Goldman spokesperson says the firm no longer does any proprietary trading.
In the fourth quarter, though, Goldman appears to have taken steps to protect itself from a drop in bond prices. Last week, the firm, as part of its earnings announcement, said the amount it could lose on any given day from a change in interest rates — something Wall Street calls value-at-risk — had dropped to $67 million from $123 million in the fourth quarter a year ago.
All banks, particularly those like Goldman that have large bond brokerage units, have to have some exposure to interest rates. And there are a number of reasons Goldman’s value-at-risk tied to interest rates could be falling. In a conference call with investors, Goldman executives said fewer swings in prices in the bond market and a generally more cautious stance among investors had played a role in lowering Goldman’s VAR number during the fourth quarter.
But Goldman’s revenue from the unit that buys and sells bonds for clients rose 10% in the fourth quarter, suggesting that the drop in VAR at Goldman wasn’t because of a lack of investor activity. What’s more, other banks don’t seem to be showing similar drops in exposure to interest rates. For instance, the amount JPMorgan Chase (JPM) could lose on any given day from changes in bond prices rose in the fourth quarter to $86 million from $56 million a year ago. The same figure at Morgan Stanley (MS) rose to $60 million in the fourth quarter, up from $51 million a year ago. Bank of America’s (BAC) interest rate risk fell slightly in the quarter. Citigroup (C) does not disclose the figure.
At Davos, Goldman’s Cohn said his main concern was how the bond market and banks would be able to deal with the fallout when investors hit the exits. “We will clearly be there to facilitate,” says Cohn. “But, ultimately, we can’t be the buyer of last resort.”
Brad Hintz, a banking analyst at AllianceBernstein, says new regulations are making it harder for Goldman and others to hold onto riskier bonds. Hintz says that could lead to a larger than normal drop in bond prices when investors’ current love affair with debt ends. “When interest rates do rise, what you are going to see is a lot of fat people trying to squeeze through a really small door.”
If that’s true, Goldman’s current bond diet could pay off.
Risk of Ultralow Yields
The great reflation by the world’s central banks has lifted more than just markets. Chief executives, bankers and politicians in Davos for the World Economic Forum last week were getting bullish, particularly on the U.S. economy, for the first time in more than four years.
But by keeping interest rates ultra low, central banks including the Federal Reserve may have created a ticking time-bomb for investors in the bond market.
Low rates have been a bonanza for many. Bond investors have earned bumper profits, while companies, homeowners and governments have refinanced debt at bargain rates. But extreme central-bank actions have triggered a search for yield, with worrying echoes of the precrisis boom when investors made bets that later backfired.
The risk is that the many retail investors who sought safety in bonds don’t fully understand the losses they could face if there is a sustained economic recovery and yields start to rise.
Right now, the bond market doesn’t appear at risk of a major selloff that could cause those losses. Enough uncertainty remains over the global economic outlook that investors are still eager to hold haven assets, even as the U.S. economy picks up steam and concerns about China and the euro zone wane. New regulations are encouraging banks and insurance companies to hold more bonds. And zero-interest-rate policies provide some anchor even for long-dated bond yields, preventing them from rising too far, too fast.
But markets can shift suddenly if sentiment changes. Should investors become convinced that a sustainable economic recovery is under way, or lose confidence in central banks’ ability to contain inflation, then yields are likely to move sharply higher.
That would inflict even more pain than in the past. Old bond-market hands remember the carnage of 1994, when the Fed raised rates unexpectedly, causing a sharp selloff. But now the stakes are higher. Money has flowed into bonds at an extraordinary pace in recent years. In the past two years alone, investors put just over $1 trillion into global mutual and exchange-traded bond funds, while pulling a net $9 billion from equity funds, J.P. MorganJPM +0.02% says.
The low yields, alone, pose a problem because of a quirk of bond math. They have made the price of bonds more sensitive to any movements in yield—or in the technical jargon, this has increased bond duration, which is determined by both the maturity and yield.
Low yields mean that more and more of the value of a bond is in the big lump sum investors get when the bonds mature, making prices more volatile. This is because the payment of that lump sum may be many years away, making the bond’s value sensitive to assumptions about interest rates. That has made long-maturity bonds, such as 10-year or longer paper, even riskier than in the past. For a one-percentage point rise in yields, 10-year U.S. Treasury holders now face a drop in price of nearly nine percentage points, versus around seven under more normal yield assumptions. Moreover, given where yields are, there is more room for them to rise than fall, meaning losses are more likely.
The benchmark 10-year Treasury was yielding around 1.95% on Friday, only a sliver more than inflation, which is running at 1.7%. If yields were to return to more normal levels of around 4%, investors would see the price of the bond fall from 97.15 on Friday to around 81, a fall of more than 16%, a huge hit for an asset many see as super safe.
Investors who hold their bonds until they mature will eventually be repaid in full. But they would have to wait until November 2022 for that, a long time to be stuck in a low-yielding investment.
With central banks seemingly on hold for months if not years, this problem is growing, as old bonds that paid high interest rates mature and are replaced with low-interest-rate debt. In Germany, for instance, €79 billion ($106 billion) of bonds that paid interest of between 3.5% and 4.25% mature in the next 12 months and will probably be replaced with debt offering far lower rates.
And it isn’t just government bonds that pose a threat. Corporate bonds increasingly sport ultralow rates. The average U.S. “junk” bond now yields just 5.6%, according to BarclaysBARC.LN -1.14% indexes. While the extra yield on this debt versus Treasurys offers some protection against rate rises, it also isn’t as liquid as government debt. If investors do decide to abandon bonds, then the selling pressure on corporate debt markets could be intense. This could be particularly marked given the surge into bond funds by retail investors in recent years. If they are spooked by bond-price falls and sell, funds would be forced to dump bonds into a relatively illiquid market, potentially creating a destructive feedback loop.
When losses come, they can build quickly. Just ask the Bank of England, the biggest holder of U.K. government bonds thanks to its quantitative-easing program, under which it has bought £375 billion ($593 billion) worth. In the first 10 days of January, it saw mark-to-market losses of £7 billion as yields rose, Bank of America-Merrill Lynch estimates, wiping out a good chunk of the paper profit the BoE had made.
There are reasons to believe that central banks will seek to prevent market yields from rising. After all, tighter credit could choke off any recovery. But by deferring problems, artificially low yields are a double-edged sword—generating savings for borrowers now but storing up losses for lenders in the future.
The time bomb is ticking.
—Thorold Barker contributed to this article.Write to Richard Barley at email@example.com
A version of this article appeared January 28, 2013, on page C1 in the U.S. edition of The Wall Street Journal, with the headline: Risk of Ultralow Yields.