FORTUNE — Goldman Sachs is growing more nervous about the bond bubble.
In the past year, the investment bank has dramatically cut the amount of money it could lose on any given day if interest rates were to rise, which would cause bond prices to fall. The bank has also upped its own borrowing in order to lock in low interest rates.
The moves mirror cautious statements recently made about the bond market by Goldman’s two top executives. Last week, at the World Economic Forum in Davos, COO Gary Cohn, who is the firm’s No. 2 executive, warned that many banks and investors might not be prepared for the possibility of a “significant repricing” in the bond market. Cohn told Bloomberg, “At some point, interest rates will go higher again, and all of the money that has piled into fixed income over the past three years, some of it will come out.” Cohn, perhaps tellingly, noted that a bond crash would be “interesting” for Goldman.
In December, Goldman’s CEO Lloyd Blankfein said at a conference sponsored by New York Times that the risk of a bond market crash was growing and that investors appeared unprepared. What’s more, Blankfein said Goldman was advising clients to increase their borrowing to take advantage of low rates.
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Goldman (GS) is taking its own advice. This month alone, Goldman has borrowed $8 billion from the bond market, including a three-part $6 billion debt offering, which was the firm’s largest ever. Some of that is refinancing. But the borrowing is up from $5.2 billion in January a year ago. And Goldman has been swapping out some of its 3-year bonds for debt that it won’t have to pay back until 2023.
The moves are reminiscent of those Goldman took in 2006 and 2007 in the run-up to the housing bust. The firm reportedly bet against mortgage bonds so that it could profit as the price of housing debt collapsed. After initially touting the bet to investors, Goldman backed off claims that it had profited from the housing bust, calling the firm’s trades merely hedges.
It’s not clear whether, or how, Goldman has made a similar bet against interest rates. A recent report from Bloomberg said Goldman had set up a secretive division that has placed $1 billion of the firm’s own money on bets on stocks and bonds, sidestepping a proposed ban on such activities. A Goldman spokesperson says the firm no longer does any proprietary trading.
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In the fourth quarter, though, Goldman appears to have taken steps to protect itself from a drop in bond prices. Last week, the firm, as part of its earnings announcement, said the amount it could lose on any given day from a change in interest rates — something Wall Street calls value-at-risk — had dropped to $67 million from $123 million in the fourth quarter a year ago.
All banks, particularly those like Goldman that have large bond brokerage units, have to have some exposure to interest rates. And there are a number of reasons Goldman’s value-at-risk tied to interest rates could be falling. In a conference call with investors, Goldman executives said fewer swings in prices in the bond market and a generally more cautious stance among investors had played a role in lowering Goldman’s VAR number during the fourth quarter.
But Goldman’s revenue from the unit that buys and sells bonds for clients rose 10% in the fourth quarter, suggesting that the drop in VAR at Goldman wasn’t because of a lack of investor activity. What’s more, other banks don’t seem to be showing similar drops in exposure to interest rates. For instance, the amount JPMorgan Chase could lose on any given day from changes in bond prices rose in the fourth quarter to $86 million from $56 million a year ago. The same figure at Morgan Stanley rose to $60 million in the fourth quarter, up from $51 million a year ago. Bank of America’s interest rate risk fell slightly in the quarter. Citigroup does not disclose the figure.
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At Davos, Goldman’s Cohn said his main concern was how the bond market and banks would be able to deal with the fallout when investors hit the exits. “We will clearly be there to facilitate,” says Cohn. “But, ultimately, we can’t be the buyer of last resort.”
Brad Hintz, a banking analyst at AllianceBernstein, says new regulations are making it harder for Goldman and others to hold onto riskier bonds. Hintz says that could lead to a larger than normal drop in bond prices when investors’ current love affair with debt ends. “When interest rates do rise, what you are going to see is a lot of fat people trying to squeeze through a really small door.”
If that’s true, Goldman’s current bond diet could pay off.
