Goldman flags $1 trillion reason for Fed to go slow on rates

If the US Federal Reserve chooses to raise interest rates, it may hit long-term debt the hardest

Lurking in the bond market is a $1 trillion reason for the Federal Reserve to go slow on interest-rate increases.

That's how much bondholders stand to lose if Treasury yields rise unexpectedly by 1 percentage point, according to a Goldman Sachs Group estimate. A hit of that magnitude would exceed the realised losses since the financial crisis on mortgage bonds without government backing, Goldman Sachs analysts Marty Young and Charles Himmelberg wrote in a note published today.

"Some investor entities would likely experience significant distress," Young wrote. "Rising yields should be on the short list of scenarios to be monitored by risk managers."

Money managers have embraced securities with longer maturities as record low interest rates around the world fuel a search for yield. Trouble is, when interest rates rise, bond prices fall - and longer-term debt gets hit hardest.

Investors have been buying longer-term bonds while the market has grown and interest payments have fallen. That means potential losses from rising rates are higher, and the income investors receive from bonds will do less to insulate them from the pain of having principal tied up at lower rates, Goldman Sachs warns.

The Fed started tightening rates in December, when it raised its main borrowing rate for the first time in more than a decade.

The median forecast in a Bloomberg survey is for 10-year yields to climb to 2.6 per cent by the third quarter of next year, from about 1.7 on June 3. New York-based Goldman Sachs sees rates advancing to 3.3 per cent by 2018.

Analysts and regulators have warned for months that rising rates will be painful for investors and lenders, but bond yields remain stubbornly low. The benchmark 10-year Treasury note yield dived the most in more than a year Friday after the monthly US payrolls report showed employers added the fewest number of workers in almost six years. That may derail Fed plans to raise borrowing costs in the coming months. Policy makers next meet June 14-15.