Written by: Nate Tonsager
Thanks to higher interest rates, many investors and even some of the largest banks are seeing major unrealized losses on their bond holdings.
It’s jarring to look at statements and see individual US government bonds, which are supposed to be “safe” investments, with major losses on paper. But if you’ve planned appropriately, these losses are nothing to fear.
Why is that? Because they are temporary.
Let’s look at a current real-life example: Bank of America (I’ll use “BofA” for short). They reported having -$131.6 billion of unrealized losses on their recent quarter-end balance sheet, mostly from US government fixed income securities. According to Reuters, US banks collectively “could be grappling with at least $650 billion of unrealized losses” from these types of securities.
How did these losses accumulate?
It’s not too complex. Interest rates moved significantly higher and subsequently crushed bond prices. Most bonds purchased years ago are now underwater from a price standpoint even if they are still paying their agreed upon interest rates. Silicon Valley Bank and a few other banks faced a similar situation earlier this year, but for them, the losses were unbearable and caused their collapse.
That was scary stuff, but I believe the worst of that banking crisis is behind us.
However, it’s important to ask: What should investors & banks who own these relatively low-yielding fixed income positions be doing today?
Nothing, if they can.
Right now, these bonds only have paper (or unrealized) losses, not actual losses. They will only become actual (or realized) if/when the bonds are sold at a loss. If they’re never sold in the secondary markets, but instead are held to maturity when the principal is repaid in full, there’d be no price losses to report.
That’s what some analysts and BofA’s own CFO expect. Ideally BofA will never need to sell these bonds and can hold them until maturity. At that point, without any defaults, they should receive their principal back effectively wiping out the paper losses we see today. It pays for them to be patient.
Thankfully BofA appears to have ample liquidity sources and a strong capital position after their recent earnings. It seems highly unlikely they will ever be forced to sell their bonds, actually realizing these major paper losses. With solid cash management, they should be able to withstand financial market volatility and avoid locking in crippling losses with required selling in tough bond market environments.
This is NOT in any way an endorsement of or recommendation for BofA stock. This is simply an anecdote to provide context on how interest rate changes have affected bond portfolios, and how investors can think about unrealized losses in their individual bond holdings. Even though paper/unrealized losses aren’t technically “real” yet, they cause actual emotional pain. That’s why it’s important to share BofA’s approach to their current unrealized bond losses.
Don’t Overreact – Stick to the Plan
Like BofA, don’t overreact; stick to the plan. If you intend to hold a bond until maturity, its price swings up & down until that point becomes irrelevant. Absent a default, and as long as you don’t need to sell it along the way, you’ll get your full principal amount back along with whatever the upfront interest rate was.
However, this strategy only works in the context of a larger financial plan. Because it always comes back to cash-flow planning complemented by ongoing portfolio and risk management. You can’t wait for a bond’s maturity if you don’t have a plan for sufficient cash today.
Having a plan is vital to make logical decisions with your wealth. It’s truly the best way to help frame discussions about what’s going on in your portfolio and with the markets at large.
Related: Decoding Market Signals: Charts, Stock-To-Bond Strength and More