Two years ago I developed a thesis about the negative effect of the Federal Reserve’s interest rate policies on bank balance sheets based on my understanding about the history of zero rates in Japan. For bank bond investors, this should be worrisome.
In November 2010, I wrote a post noting that the long end of the yield curve would come in due to the Fed’s zero rates, flattening the yield curve and compressing interest margins. This is what we witnessed in Japan in the aftermath of their housing bubble and the result was zombie banks made especially vulnerable during downturns. See my August 2011 post on toxic zero rates that spells all of this out in greater detail.
The point, of course, is that while the Fed is desperately trying to engineer a recovery by reducing debt burdens for a highly indebted household sector, its policy has the unintended consequence of reducing interest income at financial institutions, which are still overburdened by weak balance sheets.
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What does this mean? In the context of banks’ higher risk profile, lower return on equity and still fragile balance sheet, it could mean significant principal losses during the next downturn. In terms of credit, the cycle is near the peak. All indications are that investors are loading up on leveraged commercial mortgage backed securities in particular. When the cycle turns, likely a number of banks will be caught out and take losses on these riskier investments as well as legacy toxic assets already on their balance sheets. When they get into trouble, bondholders will be subject to greater losses than they now realise.
Likely, when the prospect of losses is made plain for just one large issuer, it will trigger asset class contagion and an across the board selloff in bank bonds. Therefore, it pays to examine your portfolio and gauge the risk of the bank bonds in it in anticipation of these events.