What Happens to Securities When Rates Rise

The Fed raised rates again this week, the seventh increase this year. The federal funds rate is now 4.25 to 4.50 percent. That's 425 basis points in nine months. I've been paying more attention to the securities line on the balance sheet lately, and now I'm trying to understand what all these rate hikes actually do to that portfolio.

The Inverse Relationship

The basic mechanic is straightforward. When interest rates go up, the market value of existing bonds goes down. If a bank bought a 10-year Treasury yielding 1.5 percent early in 2022, and new Treasuries are now yielding 3.5 percent, nobody is going to pay full price for that older bond. Why would they, when they can buy a new one that pays more? So the market price drops until the yield on the old bond matches what's available in the market.

The math works in both directions. When rates fall, bond prices rise. But we haven't been in that world for a while. The speed and scale of these rate increases is what makes 2022 unusual. Going from near zero to 4.25 percent in less than a year is aggressive by any historical standard, and the effect on bond portfolios has been significant.

The Accounting Split

Here's where banking accounting gets interesting. Banks classify their securities into two main categories, and the classification determines whether losses show up on the financial statements.

Available-for-sale securities are marked to market. If the bonds lose value, that unrealized loss flows through to equity on the balance sheet. It doesn't hit the income statement directly, but it reduces the bank's reported equity. That's real, and regulators see it. This part I understood intuitively.

Held-to-maturity securities don't get marked to market. As long as the bank intends to hold them until they mature, the bonds stay on the books at their original cost. The unrealized loss exists in economic terms, but it doesn't appear on the balance sheet. The bond will eventually pay back its full face value at maturity, so the accounting logic is that if you're never going to sell, the interim price fluctuation doesn't matter.

This distinction matters more than it might seem. A bank can be sitting on significant unrealized losses in its HTM portfolio without those losses appearing anywhere in its financial statements. The money isn't lost in the traditional sense. If the bank holds to maturity, it gets its principal back. But in the meantime, those bonds are worth less than what the bank paid, and that's capital effectively locked up.

The Scale

The numbers across the banking system are striking. The FDIC reported roughly $690 billion in unrealized losses across all banks as of the third quarter of 2022. That reflects what happens when an entire industry holds long-dated bonds purchased during a period of historically low rates, and then rates move sharply in the other direction.

Community banks aren't immune. Securities are typically the second-largest asset category on the balance sheet, right behind loans. The composition varies, but most community banks hold a mix of Treasuries, agency mortgage-backed securities, and municipal bonds. All of those lost market value this year.

What I'm Thinking About

It comes down to duration. Longer-dated bonds got hit the hardest because there are more years of below-market payments built into the price. A 2-year Treasury adjusts quickly. A 10-year or a 30-year mortgage-backed security carries that gap between the old rate and the new rate for a long time, and the market prices that in immediately.

So the composition of the portfolio matters as much as the size. A bank holding mostly short-duration bonds would have taken a much smaller hit than one loaded with long-dated securities. I'd guess a lot of banks extended duration during the low-rate years to pick up yield. That's the trade that looked smart at 1.5 percent and looks painful at 4.25.

The bonds will mature eventually. The money comes back. But until then, this is a real constraint on the balance sheet, especially for banks that might need liquidity and find that selling securities would mean realizing those losses for real.