How a rate hike broke Silicon Valley Bank: duration risk, in real life

In March 2023, the second-largest bank failure in US history played out in about 48 hours. The cause was not a bad loan or a fraud. It was a portfolio of safe government bonds.

Silicon Valley Bank had taken its flood of pandemic-era deposits and bought long-dated Treasuries and mortgage-backed securities, among the safest assets in the world by credit risk. But credit risk was never the danger. When the Federal Reserve lifted interest rates from near zero to roughly 4.5% over 2022, the market value of those long bonds fell hard. By early 2023 the bank sat on enormous unrealized losses; when it sold a block of securities at a $1.8 billion loss to raise cash, depositors tried to pull roughly $42 billion in a single day. Regulators seized the bank the next morning.

The metric that measured the danger the whole time appears on the curriculum: duration.

What duration actually measures

Duration is the sensitivity of a bond's price to a change in interest rates. A bond with a duration of 8 loses roughly 8% of its value when yields rise by one percentage point, and gains roughly 8% when they fall. Longer-maturity bonds have higher duration, so they swing more.

This is the mechanism behind the collapse. Long-dated bonds carry high duration, rates rose by several percentage points, and so the price decline was severe, exactly what duration predicts. The bonds were "safe" in that they would repay par if held to maturity. They were dangerous in that, marked to today's market, they had fallen far below cost, and the bank needed the cash now, not in a decade.

The convexity refinement

Duration is a straight-line estimate, but the real price-yield relationship is curved. Convexity is the correction for that curve: it tells you duration slightly overstates the loss when yields rise and understates the gain when they fall. For small moves the duration estimate is close; for the large moves of 2022 the curvature matters, and it works modestly in the bondholder's favor versus the straight-line estimate.

What it tests

SVB is interest-rate risk made literal. A bond's price moves opposite to its yield; duration measures how much it moves, and longer bonds move more. An institution that funds long-duration assets with money that can leave overnight is running exactly the mismatch duration is built to flag.

"Safe" describes credit risk. Duration describes price risk. A bond can be flawless on credit risk and still sink the bank that holds it on price risk.