How can notional losses hurt in reality?

June 26, 2024

Did you see this headline last week?

Norinchukin Bank, a Japanese bank, is selling $63B worth of US and European Government Bonds. The reason is that the bank wants to stem losses from low-yielding foreign government bonds it has purchased in the aftermath of Covid.

But hey, if they held the bonds until maturity, there would be no losses. So why are they selling them?

Let us first understand how bonds work. I will use approximate figures to drive home the point.

Let’s say you invested 1 lakh in an 8% 10-year government bond last year. You will earn 8,000 as annual interest income for 10 years. At the end of 10 years, you not only collect 8,000 as interest but also get your principal, 1 lakh, back. 

Sounds straightforward right? But there are a few small things that can change the equation. During the tenure, the interest rate in the economy can either increase or decrease or stay flat. 

What if interest rates move in the period before maturity?

If the interest rates fall to 6%, you will still make 8000 per month, but the value of your bond will go up to roughly 1.33 lakh. So, if someone wants to buy this bond from you, they will have to pay you 1.33 lakh. You will make 33000 as profits. Going forward, the annual interest income of 8000 will go to that buyer. For them, the yield will be ~6% (8000 / 1.33 lakh). 

You may still not want to sell the bond because of reinvestment risk. If you invest the 1.33 lakh you received in a different bond with a similar profile, you will most likely earn a yield of 6% only. Reinvestment risk is when the high-yielding investment that matured or you redeemed can be reinvested only at a lower yield.

Consider a different scenario. If interest rates rise to 10% one year later, the bond price will adjust to make the 8,000 interest earnings 10% of the price. This means that the buyer will pay roughly 80,000 to buy the bond from you. You will have to sell the bond at a loss. For the buyer, the yield will be 10% (8,000/80,000).

You may still want to sell at a loss because of reinvestment gains. You can invest the 80000 in a different bond with a similar profile and earn a 10% yield. Moreover, if interest rates were to fall after this, the market value of your bonds would rise while you would continue to earn an annual interest income of 8000.

This was one reason why Norinchukin Bank decided to sell its low-yield bonds. It can reinvest the proceeds in higher-yield bonds.

But these interim losses or profits would not matter if the bank held the bonds until maturity. It will get the principal investment back, and will have also earned the coupon payments every year.

However, interest rate movements impact the bank’s “reported” performance. Note the quotes on “reported.” Depending on how they have categorized a particular investment, banks have to report the market value of their holdings in their quarterly performance reports.

So, when the bond’s value rises, it adds to the bank’s profits. And when the bond’s value declines, it adds to the bank’s losses. Basically, the bank has to mark to market (M2M) the value of its investments. These are not cash profits or losses, only notional ones, but the bank still has to report them.

The loss reporting is reducing the bank’s equity, thereby stifling its ability to lend. The bank could still hold on if it sees interest rates falling and bond value reviving. But the bank perhaps expects interest rates to go higher up. Higher interest rates than the current levels would mean a further decline in the market value of the bonds.

Holding on to these bonds would mean reporting more losses in the subsequent quarters. Selling the bonds and reinvesting the proceeds at higher yields would add to the bank’s profits and equity. If interest rates were to fall sometime in the future, the bonds’ value would rise, thereby improving the bank’s equity and ability to lend.

And let’s not ignore the market. Irrespective of why the bank reported losses, it is likely the markets will punish its stock price. Reported profits sound more reassuring than reported losses. The market’s negative sentiment can lead to the bank’s customers taking out all their deposits. In order to not let the market panic convert into panicking customers, Norinchukin Bank’s move seems logical.

Content, Zerodha Varsity

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