fixed income bubble

Sign of the Times: Century Bonds

© Can Stock Photo / webking

A curious example of messed-up interest rate markets has emerged recently. Certain countries and companies have successfully issued bonds at fixed rates of interest for ultra-long terms. Fifty or one hundred years is a long time.

To put these in perspective, it might be helpful to go back to the 1950’s. The largest insurance company in the world, Prudential, invested in a bond issued by General Motors. It was $100 million dollars in a century bond – maturing one hundred years after issue – for 4% interest. A couple of lessons about risk might be learned from this story.

Interest rate risk is a thing that affects bonds. When rates rise, the value of existing bonds declines. What is a 4% bond worth in a 15% world? By the early 1980’s, with seventy years remaining on this GM bond, the answer would have been less than 30 cents on the dollar.

But if a long term bond is held to maturity and pays the principle back as promised, the potential market value loss from higher interest rates is avoided, right? Sure. But that is not what happened.

The second lesson about risk came into play in 2009, when General Motors filed for bankruptcy. Creditors received less than 20 cents on the dollar in the liquidation of GM. So this supposed century-long investment came to a bad end, more than forty years early. When you lend money to somebody that turns out to be a deadbeat, you learn about credit risk.

These lessons of history are pertinent now, as Austria joins Italy and Mexico as issuers of century bonds. The most recent Austrian issue yields just 1.2%. Do you wonder how this could possibly work out?

We have characterized the movement into fixed income securities in recent years as a stampede before. Irrational pricing and large volumes of issuance are the hallmarks of a stampede, in our view. This is our opinion – it may be wrong. We have no guarantees.

As we watch the current revival of century bonds unfold, we’ll be thinking about the history of these instruments, and scratching our heads. Clients, if you would like to talk about this or anything else, please email us or call.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

 

The Risk You Don’t See

© Can Stock Photo Inc. / larryhw

United States Treasury Bonds have long been considered among the safest investments in the world. But bonds with extended maturities, twenty or thirty years, have a lot of risk. This risk seems invisible and under-appreciated in today’s environment.

How would you like a twenty year long term Treasury bond paying 7%? Would that be good for you? People thought so in 1977. But by 1982 when interest rates had risen to almost 15%1, those bonds were only worth fifty cents on the dollar. Worse yet, inflation ramped up and damaged the purchasing power of interest earnings. When rates rise, the value of existing bonds goes down.

Since the financial crisis of 2007-2009, hundreds of billions of dollars have gone into bonds—a record tidal wave of money. One might guess this represents a flight to safety amid the uncertainties of the world. Some people got hurt in real estate, some were hurt by selling stocks after a crash, and they just want to keep their money safe.

Behavioral economics has shown that we humans tend to believe that current conditions and current trends will continue into the future. So if we pose the question, “What will a 2% bond be worth in a 5% world?,” most people can’t even conceive of the possibility of 5% interest rates. While everybody seems to understand that the stock market goes up and down, few seem to remember that the bond market also goes up and down.

As inflation begins to pick up, investors may be leery of owning 2% bonds that are going backward in purchasing power. If the sellers come out, bond values may decline while interest rates go up. The more selling, the greater the losses, which produces even more selling.

We are not predicting this will happen. But we do know a similar situation happened in the past. Fortunately, we are working on ways to preserve capital without facing the large risk from rising interest rates. If you would like to know more, please call or email us.

1Data from St. Louis Federal Reserve

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.