U.S. Bank Capital at Risk When Bond Gains Evaporate, Fitch Says

About $25 billion in unrealized bond gains are at risk from rising interest rates that may erode capital levels at some of the largest banks by 1 percentage point or more, according to Fitch Ratings.

Four years of price appreciation and growth in the bond portfolios of the 15 largest banks have left them with unrealized gains approaching a two-decade high, Fitch said today in an e-mailed statement. The gains may be erased by rising interest rates in a manner that could be worse than the last cycle when gains topped out in 2002, according to the ratings firm.

“Today’s pattern of investment portfolio price appreciation deviates from the prior rate cycle,” Fitch said, citing the 2002 peak. “Relative to that period, we believe banks face additional downside risk now given the significant price appreciation seen in fixed-income securities during a prolonged low-rate environment.”

Fitch is the latest to warn of an impending reversal of bond prices as Federal Reserve bond purchases drive down interest rates and lead investors searching for returns to push junk-bond yields to below 6 percent. Goldman Sachs Group Inc. Chief Executive Officer Lloyd C. Blankfein has warned that the interest-rate environment has parallels to 1994, when a sudden and sharp increase in rates caught many investors off-guard.

An “immediate reversal” of bond gains in bank portfolios as seen in the last cycle could trim 1 percentage point from the capital levels at four of the largest 15 lenders under Basel III rules, Fitch said. Fitch declined to identify the banks, or detail years included in the last cycle.

Yields on junk-rated bonds reached an unprecedented 5.984 percent on May 9 before rising to 6.043 percent yesterday, according to the Bank of America Merrill Lynch U.S. High Yield index. Junk, or high-yield bonds, are rated below Baa3 by Moody’s Investors Service and BBB- at Fitch and Standard & Poor’s.

To contact the reporter on this story: Dakin Campbell in San Francisco at dcampbell27@bloomberg.net

To contact the editor responsible for this story: David Scheer at dscheer@bloomberg.net

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