Long Bonds

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June 7, 2016

Let’s call this post “The Sunday Read.”   I hope you find it entertaining and thought-provoking. 


PIMCO has long been known as the experts when it comes to bonds and bond trading.

In a 2007 paper entitled “Duration: The Most Common Measure of Bond Risk“, here’s what they had to say:

“Duration is the most commonly used measure of risk in bond investing. Duration incorporates a bond’s yield, coupon, final maturity and call features into one number, expressed in years, that indicates how price-sensitive a bond or portfolio is to changes in interest rates.

There are a number of ways to calculate duration, but the generic term generally refers to effective duration, defined as the approximate percentage change in a security’s price that will result from a 100-basis-point change in its yield. For example, the price of a bond with an effective duration of two years will rise (fall) two percent for every one percent decrease (increase) in its yield, and the price of a five-year duration bond will rise (fall) five percent for a one percent decrease (increase) in its yield. Because interest rates directly affect bond yields, the longer a bond’s duration, the more sensitive its price is to changes in interest rates.”

Notice the bold text in the paragraph above.  This is critically important.  As the article heading says, duration – think of this as the number of years before the bond is due and payable – has the greatest effect on the underlying value of a bond as rates rise or fall.

Bill Gross, the man who put PIMCO on the map, is arguably the most savvy bond investor of our times.  In his most recent Investment Outlook blog, Bill commented, “The bond market’s 7.5% 40-year historical return is just that – history. In order to duplicate that number, yields would have to drop to -17%!  Tickets to Mars, anyone?

Yes, you read right:  That’s a negative 17% yield.  I think we all agree with Bill:  The odds of that happening are nonexistent.  Solidly zero.   (Read Bill’s entire blog here:  https://www.janus.com/bill-gross-investment-outlook)

Look, we can have a meaningful discussion about how low interest rates will go.   And we can even debate how long we feel rates will remain low.   But I don’t think anyone would willingly take the side of the debate suggesting interest rates – of any duration – will fall significantly further below zero.   These are definitely interesting times in the financial markets, but I think every participant, worldwide, would agree that the probability of rates rising – someday – is far greater than the opposite.

Which means bond owners should be somewhat concerned about duration…yet, for some odd reason, there doesn’t seem to be much concern.   And I mean anywhere.

For example, recently Spain decided to create and sell a new $10 billion bond issue.  One that matures in 50 years.   That’s right:  50 years.  The investors will get their money back in 2066.  Of course, they will get paid a whopping 3.48% per year.   For 50 years.   Compared to the current yield on a 5 year of about 1.5%, this is pretty good!

But wait!  There’s more!  How about a 100-year bond?  Interested?  Well, Ireland and Belgium both recently sold $100 million in 100-year bonds.  Boy, for a 100 year commitment, you’d think you would receive one heck of a high interest rate in return, right?  Nope.  The Irish bond yielded a paltry 2.35%.   About the same for Belgium.

So what do you think?  Does this bond holder have some duration risk?  You betcha.  In fact, let’s say, for the sake of argument, the owner of this bond chooses to sell it in, say, 5 years.   And let’s assume long-term (meaning 30-year) interest rates go up 1.00% by that time.  Not an unreasonable scenario, right?

Well, in this scenario, the value of the bond has probably fallen 95%.   $100 of principal value would now be worth $5 to a new investor.  In theory.  Of course, the bond owner can eliminate this ‘paper’ loss if they simply hold the bond until it matures – and they get paid their original $100 back.  That will happen in 2116.

Why would an intelligent investor take that kind of risk?   It can’t be the spectacular 2.35% yield.  Then what could it be?

Let’s move back closer to Earth and look at 10-year yields.   Here’s the most recent global chart from Tradeweb:

10 year yields

Remember:  This is 10-year rate data.  Japan is solidly in the red.   Germany isn’t far off.  And this data is 2 months old.   Let’s take a look at the most recent European 10-year update from Tradeweb:

10 year yields may

Look at the second column, “Change on previous month”.  With the exception of Portugal, every European country saw 10-year yields move slightly lower.

This might not be overly concerning if the value of these bonds, collectively, was small.  But it isn’t.

According to a Fitch Ratings press release a few days ago, “The total amount of fixed-rate sovereign debt trading at negative yields grew modestly to $10.4 trillion ($7.3 trillion long term and $3.1 trillion short term) as of May 31, up 5% from the $9.9 trillion that Fitch calculated as of April 25. There were no major shifts in the distribution of debt among the 14 countries with negative-yielding debt, with Japan still by far the largest source. Modest declines in Japanese, Italian, German and French sovereign yields during the month drove the $0.5 trillion increase in the total stock of negative-yielding debt.

(Read the press release at:  https://www.fitchratings.com/site/pressrelease?id=1005505)

OK…what’s my point?

Investors take money very seriously.   Losing money is very undesirable.  And yet we have many trillions of dollars in debt instruments trading at interest rates that seem almost certain to create massive principal (duration) losses when rates rise.  What possible explanations can their be for this choice?  I see two.

One, some form of mass insanity disease has slowly drifted down from the sky, settling over and infecting investment experts and their clients/customers.   Some new form of a ‘stupidity plague‘ if you will.   This would not be unprecedented.   It last happened between 2004 and 2008 with the global ‘sub-prime stupidity disease.’

But a more likely explanation is investors actually believe bonds at these ultra-low yields are a good, solid, prudent, long-term investment choice.  For some reason, one that remains opaque to me, they believe lending money for 10-, 50- or even 100-years at interest rates humanity hasn’t seen since debt was created about 4,000 years ago is a prudent choice.

Personally, I don’t see it.   Perhaps you do.  But I don’t.   Feel free to send me back your thoughts if you have some wisdom to share.  I’d be very interested.  Thanks for letting me prattle on.

  • Terry Liebman

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