Beware the ultra-long trap

The bond market world has moved into strange territory of late. Around one quarter of the debt issued by governments and companies is currently trading at negative yields and in Germany government bonds are yielding negative rates of interest out to a maturity of 30 years. In effect, investors are paying the government for the privilege of owning their debt, quite a long way out across the maturity spectrum. This does not mean that investors periodically hand over a sum of money to the government, but it does mean that the stream of income that the bond pays is less than the amount the investor paid for the bond.

Why would anyone be prepared to do that? The simple answer is that investors need the reliability and liquidity that high quality bonds can provide when they have to allocate their portfolio over a wide range of assets. Think of it this way: Even though investors would have maximised their returns over the past decade if they had been fully invested in equities, at no point could they ever be sure that the bandwagon would keep on rolling. Theory suggests that long-term returns are maximised if the portfolio is spread across a range of assets, and the likes of pension funds are required to allocate a minimum portion of their portfolio to bonds in order to meet their payout obligations. Even now pension fund providers will not hold less than 40% of their assets in bonds, and although the returns may be miserable the buyers of high quality government (and corporate) debt are highly likely to get their money back. The bond market is thus a safe place to store wealth – a hedge in an uncertain world.

On the basis that demand for bonds is unlikely to dry up, despite low interest rates, governments arguably have a strong incentive to issue debt at current low rates, either to finance additional spending or refinance existing debt. Moreover, they have an incentive to issue much longer maturity debt than previously in order to lock in these rates for as long as possible. One would think that no rational investor worth their salt would buy bonds issued with a negative coupon rate. Think again. In August, the German Federal Finance Agency sold a 30-year zero coupon bond (i.e. it pays no interest) but because the bond was sold at 3.61% above par (i.e. investors pay 103.61 but receive only 100 at maturity) this amounts to a negative interest rate of 0.11% per annum if the bond is held to maturity. Demand fell short of target, with sales of €824 million versus a target of €2 billion, but it was generally perceived as a useful trial of the extent to which the market was prepared to accept low rates.

In 2017, before yields fell to current levels, two countries – Austria and Argentina – decided to test the demand for ultra-long issuance by selling 100 year bonds. Their experience has been rather different, with the price of the long-term Argentinean bond since halving in value whereas the Austrian bond has doubled. It is understandable that Argentina tried to lengthen the maturity of its debt profile – it has been a serial debt defaulter over the last 70 years with five episodes of default or rescheduling since 1950, so it made sense to reduce disruptions caused by debt rollovers. But this history also weighs on investors. Can Argentina really be trusted not to default on its debt in the next 100 years? In order to get investors onboard, Argentina had to issue at a coupon rate of 7.9%. That might seem high in the context of the US or Europe, but with the central bank benchmark rate at 74.98% and 10-year yields currently trading at almost 28%, it does not sound quite so bad.

One country which could conceivably get away with issuing longer dated bonds at low coupons is the US where the Treasury, which only issues as far ahead as 30 years, is mulling the possibility of going even further out along the curve to maturities of 50 and even 100 years. Treasury Secretary Steven Mnuchin said last month that “we are looking at potentially extending the portfolio. If there is proper demand, we will issue 50-year bonds.” He went on to suggest that if these bonds prove to be a success, the US would consider the possibility of 100-year bonds. Historically, the US has issued debt at longer maturities and between 1955 and 1963, it sold bonds at maturities up to 40 years (here). In 1911, it even issued a 50 year note to fund the construction of the Panama Canal.

But as attractive as long-term issuance sounds, there are a number of factors to consider. History cautions that issuers have to strike a balance between offering yields which are sufficiently attractive to investors but which minimise the costs to the issuer, and as the US found in the 1950s and 1960s that is a difficult balance to get right. One of the reasons for sticking to the current maturity schedule is that the US Treasury has tried to avoid tactical or opportunistic offerings of debt, and has focused instead on maintaining a regular and predictable schedule. This has helped the US Treasury market to become amongst the most liquid financial markets in the world. This in turn allows the government to offer relatively low coupons in return for the privilege of liquidity and helps to keep down Federal debt servicing costs. Issuing ultra-long debt threatens to reduce market liquidity which might in the long-run push up US rates.

Odd as it may sound, almost 20 years ago there were fears that rapid US growth and declining budget deficits would lead to a shortage of Treasury securities. Obviously that never happened, but in a world where there is a move to increasing the duration of debt we could get to a situation where there are temporary issuance droughts which could distort the shape of the yield curve. If there is an increase in the proportion of debt issued at longer maturities, a prolonged period of reduced issuance – perhaps because of rapid growth and smaller fiscal deficits – could mean a shortage of supply at the short end of the curve which would push down yields (i.e. raise prices) and result in a significant steepening of the yield curve. The point may be hypothetical but it demonstrates that changing the duration of debt issuance could have significant market consequences.

It is a mark of desperation that investors would even consider buying such long-dated bonds, particularly at a time when global uncertainty appears so high. Although the US continues to issue the world’s reserve currency, in which case it makes sense to buy dollar bonds, we cannot say that will be the case in 100 years’ time. Nor can we be sure that even the US will be able to pay its debt. After all, those British and French creditors hoping that the Russians would finally pay up on their pre-1918 debt are still waiting. And if we cannot be sure that even the US will pay up, who can we trust?