Banks close €2trn carry trade as rate rises loom
Government bond holdings have fallen by €180bn over last year
Once viewed as a lucrative and risk-free carry trade, the €2trn of government bonds held by Europe’s banks is fast becoming a source of worry, with some choosing to unwind their positions before interest rate hikes leave them with potentially large losses.
Flush with cheap loans from the European Central Bank that began in 2011, the region’s lenders piled into government bonds, increasing holdings by €540bn as they spotted an attractive carry trade that netted some hundreds of millions a year in profits.
But, with rate rises – and a possible drop in bond prices – on the horizon, that trade has now gone into reverse. Government bond holdings have fallen by almost €180bn over the last year, with some banks reducing their exposure by as much as half.
The selling comes at a tricky time for European government debt. The ECB has already begun reducing its monthly purchases and is expected to phase them out further next year. Elections due in Italy could also be a source of volatility.
“It’s a form of self-help,” said a board member at one of Europe’s largest banks that has been reducing the more than €100bn of government bonds on its books. “We are now enacting a plan in anticipation of future interest rate policy.”
A sell-off in government bonds in the second half of last year has helped focus attention. Longer-dated maturities were particularly badly hit, with prices of 30-year Bunds falling by 20% over just three months, following a market reassessment of the outlook for rates.
With several banks including BNP Paribas, BPCE, Societe Generale, Deutsche Bank, UniCredit, BBVA and Santander sitting on more than €100bn of government bonds – and an average of half marked to market – small moves can be painful.
Many of the larger banks, some of which were hit with mark-to-market losses last year, have been spurred into further de-risking. But there are concerns that some smaller banks have opted to keep the carry trade on, in the hope that bond markets won’t crash.
“The well-managed banks are definitely on top of this,” said one analyst at a US investment bank. “But the banks that might be struggling more – and thankfully there aren’t that many of them any more – are the ones that are incentivised to take on more risks, and the ones vulnerable to potential losses.”
The experience of Caixabank has certainly made some reluctant to cut. Over the past few years, it has slashed its sovereign holdings by half as it sought to get ahead of a rates rise. But the strategy has been costly, leading to a profit warning because of the lost carry.
“If all banks were privately held, the natural thing to do would be to sell the bonds now,” said the analyst. “Margins would suffer as the carry trade is closed, but you protect yourself against losses. Unfortunately, the market tends to punish banks for a drop in their margins … which is why some banks won’t do it.”
Many of those weaker banks are more exposed to falling bond prices because of short-sighted accounting changes to how they book their sovereign bonds. Bond prices have rallied substantially since 2011, which led to many reclassifying their holdings as available-for-sale rather than hold-to-maturity.
While the reclassification helped them book one-off gains, boosting profits and capital, the bonds must now be marked to market on a quarterly basis. Hold-to-maturity holdings don’t need to be marked to market – and only one switch in reclassification is allowed.
Analysts say that, if banks don’t want to sell and lose the carry, they have three options: they can lower the duration of their portfolios; they can enter into swap agreements to hedge rate rises; or they can “cheat” accounting rules by selling bonds, buying them again and shifting the “new” investments into the hold-to-maturity bucket.
Some believe that the fear of potential losses on sovereign debt holdings could actually prompt the ECB to hold rates lower for longer. The central bank has already shown some leniency – a few years back, it was pushing for banks to hold more capital against sovereign bond holdings, but those efforts seem to have quietly died a death.
“It’s a big problem and the reason why rates won’t go up,” said one analyst at a ratings firm. “Politicians and central bankers are happy with the current situation. Central banks know they will get the blame if they allow the losses to occur.”