FIN 366 Week 1 Financial Markets and Asset Pricing Example

Why a Community Bank's Bond Portfolio Lost Value When Rates Rose: Pricing Bonds and Stocks, Duration and What Markets Signal, Seen From a Composite Bank's Investment Committee

[Student Name]

University of Phoenix

FIN/366: Financial Institutions

Week 1 Assignment

[Instructor Name]

[Date]

The bank and its portfolio are composites written for a model paper; concepts and research findings come from the sources listed.

A composite community bank with $1.8 billion of assets makes loans to local businesses and households and invests excess deposits in high-quality bonds. When rates were low in 2021, it bought about $400 million of Treasury and agency bonds with maturities of seven to ten years. As rates rose over the following two years, the market value of those bonds fell well below their cost. Members of the bank's investment committee, several of them local business owners, asked why safe government bonds could lose so much. A government bond can be free of default risk and still lose a large part of its value, because its price depends on today's interest rates, not the rates when it was bought. This paper explains how markets price such assets.

What Financial Markets Do

Financial markets move funds from savers to borrowers, set prices that signal the cost of capital and give investors liquidity. Debt markets trade bonds and loans; equity markets trade ownership shares. Money markets handle short-term instruments, and capital markets handle long-term ones. The bank participates in all of them: it borrows short-term through deposits, lends long-term and invests in bonds (Mishkin, 2022).

Pricing a Bond

The market values a bond by discounting each coupon and the final principal at the yield investors now demand on bonds of similar risk and maturity. Consider a ten-year Treasury note with a 4% coupon, paying $40 a year per $1,000 of face value. When the market yield is 4%, its price is $1,000. If yields rise to 4.8%, the $40 coupons and the $1,000 principal are discounted at 4.8%: the present value of the coupons is about $312 and of the principal about $626, for a price of about $938, a loss of about 6.2%.

The bank bought many of its bonds when yields were near 1.5%. A ten-year bond with a 1.5% coupon, priced at par then, would be worth only about $778 per $1,000 when yields reach 4.3%, a loss of more than 22%.

Duration

Duration measures how sensitive a bond's price is to changes in yield, roughly the percentage change in price for a one-point change in yield. A ten-year bond with a low coupon has a duration near nine, so a three-point rise in yields cuts its price by roughly a quarter. A two-year note has a duration near two and would lose only about 6%. The bank's losses were large because it had lengthened maturities to earn a little more yield when rates were low, increasing its duration.

The Term Structure

Yields differ by maturity. The yield curve, which plots yields against maturities, usually slopes upward because investors demand a premium for tying up money longer and bearing more rate risk. During 2022 and 2023 the curve inverted, with short-term yields above long-term yields, reflecting expectations that the Federal Reserve would eventually cut rates. An inverted curve squeezes banks that fund long-term assets with short-term deposits.

Pricing a Stock

The same discounting logic values stocks. The constant growth model, associated with Gordon (1959), values a stock as next year's dividend divided by the required return minus the growth rate. A utility paying a $2.40 dividend expected to grow 3% a year, with a required return of 8%, is worth $2.472 divided by 0.05, about $49.44. If rising rates push the required return to 9%, the value falls to about $41.20. Rising rates lower stock prices too, especially for companies valued on distant cash flows.

Market Efficiency

Fama (1970) described efficient markets as ones in which prices fully reflect available information. If the bond market is efficient, the committee cannot expect to predict rate moves better than the market; the bond prices it pays already reflect expected rates. That argues for managing interest rate risk, by matching the duration of assets to that of liabilities, rather than betting on rates.

The Lesson of 2023

In March 2023, several banks failed after depositors withdrew funds rapidly. One of them had invested heavily in long-term bonds when rates were low; as rates rose, their value fell, and when uninsured depositors withdrew, the bank had to sell bonds at a loss, which eroded its capital. The episode showed that interest rate risk, not only credit risk, can threaten a bank's survival when combined with unstable funding.

What the Committee Should Do

The committee should measure the portfolio's duration against the bank's deposits and set a limit, shorten new purchases, consider holding some bonds as held to maturity where accounting and liquidity allow and model how deposit outflows would force sales at a loss. It should also track unrealized losses relative to capital each month.

Deposits Are Assets' Mirror

The bank's risk depends on its funding as much as its bonds. Most of its deposits are insured checking and savings accounts from local households and businesses, which tend to stay even when rates rise, but about a fifth are large uninsured business deposits that could move quickly. The committee therefore compared the bond portfolio's duration with the expected behavior of deposits: stable deposits can fund longer assets, while volatile ones cannot. Matching the two is the practical application of everything in this paper.

Accounting for the Losses

Most of the bank's bonds are classified as available for sale, so unrealized losses reduce equity through other comprehensive income but not net income. Regulators allowed most community banks to exclude those losses from regulatory capital, which masked the economic loss. The committee should look at the losses whether or not they reduce reported capital.

Conclusion

The bank's safe bonds lost value because their fixed cash flows were discounted at higher market yields, and long maturities made the losses larger, as duration measures. Stock prices respond to the same logic. Efficient markets mean the committee cannot outguess rates, so it should manage the mismatch between its assets and funding rather than accept large duration in search of yield.

References

Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. The Journal of Finance, 25(2), 383-417. https://doi.org/10.2307/2325486

Gordon, M. J. (1959). Dividends, earnings, and stock prices. The Review of Economics and Statistics, 41(2), 99-105. https://doi.org/10.2307/1927792

Mishkin, F. S. (2022). The economics of money, banking, and financial markets (13th ed.). Pearson.