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Less than 1% for 100 years: watch the price risk on long bonds

In June 2017, Argentina sold US$2.75 billion of 100-year bonds at a yield of 7.92%. At the time I wrote that this was crazy and reflected a desperate chase for yield that had spilled over into emerging market debt. Now that Argentina has defaulted, for the fifth time in the last 40 years, its bonds are trading at around 40% of their face value.

Just over a week ago, Austria sold €2 billion of 100-year bonds at a 0.88% yield. So, what would it take for Austria’s bonds to trade at the same price as Argentina’s?

It's not all about the credit

Those who are familiar with the credit profiles of the respective nations might think I’m crazy to make such a comparison. It’s a fair point as Argentina had a B rating from S&P in 2017 and Austria currently has a AA+ rating. I’m not going to argue that Austria has meaningful default risk now, though over 100 years almost anything could happen.

Rather, I’m thinking about what a change in interest rate expectations could do to Austria’s century bond price.

We obviously live in a world where almost no one has any expectation of central banks lifting overnight rates soon. Low growth forecasts and low inflation expectations are widely assumed. However, the enormous amount of quantitative easing, the structural weaknesses of the European Union and/or the expected surge in government debt to GDP ratios could change the outlook. Given we are talking about 100 years this doesn’t need to happen in the short or medium term to have a substantial impact on long-term bond yields and prices.

Another risk is that economists, politicians and central bankers start to acknowledge that low interest rates and quantitative easing are short-term gain at the cost of substantial long-term pain. Inflated asset prices, debt bubbles, zombie companies, depressed economic growth and greater boom/bust cycles are all associated with current central bank policy settings.

Just as many learnt about Minsky cycles after the credit crash in 2007-2009, so many are starting to learn about the long-held positions of the Austrian economic school now. Keynesian and Modern Monetary Theory (MMT) economics are the establishment position currently. However, as major economies continue to be stuck in funks lasting decades (think Japan and Europe) the search for a better solution will grow.

The policy prescriptions of Austrian school economics have served Western economies well for hundreds of years and have created enormous growth in the living standards of their citizens. Those who care to look past the short term almost always become proponents of its key tenants of small government with limited interference in the economy, a strongly competitive private sector and a focus on freeing individuals to pursue their own prosperity.

It would be supremely ironic if a return to the wisdom of Austrian school economics brought about a crash in the price of century bonds issued by Austria!

The extraordinary price falls from rate rises on a 100-year bond

It’s time to conduct some simple modelling of what impact this would have on bond prices.

First, the small moves, where a 1 basis point change (i.e. from 0.88% to 0.89% yield) results in a 0.66% drop in the bond price. Or a 10 basis point (0.10%) increase in the yield on this bond results in a 6.37% drop in the bond price.

Second, if we start to consider substantial shifts in yields, which might occur after a build-up of evidence of a V-shaped recovery, then the bond falls by 27.1% and 45% for a 0.50%/1.00% increase in yield respectively.

That's right. A 1% rate rise and the price falls by almost half. These would be enormous losses that many investors in government bond portfolios would be horrified to see.

Lastly, some interest rate regime change scenarios, which could occur as a result of inflation spiking or central banks normalising monetary policy. A 1.50% increase in yield, from 0.88% to 2.38%, sees a 57.1% drop in the bond price.

That’s the same ballpark as the fall in Argentina’s bond price. A normalisation of rates to 4% or 5% would see the bond price fall by 76.5% and 81.8% respectively. Those outcomes would be slightly worse than an average corporate bond default with a recovery rate of around 35%.

All while Austria remains a strong credit.

 

Jonathan Rochford, CFA, is Portfolio Manager for Narrow Road Capital. This article contains general information only and is not a substitute for professional and tailored financial advice. 

 

4 Comments
Peter Thornhill
July 09, 2020

Sounds like speculation to me.

Warren Bird
July 09, 2020

Not at all.

First thing to realise is that a 100 year bond is not 3.5 times the duration risk of a 30 year bond. So the difference between that and what many investors in global markets already purchase is not as significant as the headline of the term to maturity makes it sound.

Second thing to realise is that, despite Jonathan's concerns about the potential for uninformed investors to purchase an Austrian 100 year bond, the actual situation is that the market for it is going to be long term funds like insurance funds that do this all the time. they know that the net present value of the final payment is almost zero already and it's the income flow they're after.

Third thing to realise is that they'll buy a 0.88% yielding bond because it is laid off against a long term obligation they have that they've discounted at a similar rate. That is, the income flow is suitable to their needs, which is why the market for these bonds exists in the first place.

Fourth thing to realise is that they know very well that if the yield goes up there's a capital value hit in the short term, but because they make an income decision they know that their reinvestment return will increase in that situation, which is what they're after.

So, if an investor who doesn't think like that buys this as a punt that the yield will drop and they'll make a massive short term capital gain, then that's speculation. But the market for 100 year Austrian government bonds is soundly based. The same investors bought Disney's 100 year bond back in the 1990's (I think it was) and they've bought the other long term securities that are out there. Is there duration risk? Sure. But they know that; they know what they're doing.

Warren Bird
July 09, 2020

But Jonathan, if the yield increases then you can reinvest at that higher yield and the total return over 100 years will end up being higher than 0.88% per annum. Over such a long term, reinvestment returns are a much more significant feature of bond total returns than they are for short term securities, as you know.
And the vast majority of those buying such long duration bonds are insurance and other funds with long term liabilities they need to hedge, so they will be reinvesting.
And in 100 years time the bond will repay at $100 no matter what the price does along the way. (I've written about that many times, but this article was quite popular - and it would apply to a 100 year bond in the same way as it did for this 10 year bond. https://www.firstlinks.com.au/journey-life-fixed-rate-bond )
What you've said is not wrong - the price could fluctuate by the amounts that you've calculated. But honestly, anyone who buys an X year bond with a time horizon of less than X years has rocks in their head, or is a speculator rather than an investor.
And, btw, if yields fall to, say, 0.38% for that bond, then there's a handsome capital gain awaiting. Not that that matters either.

Jonathan
July 10, 2020

Hi Warren - thanks for taking the time to comment. I agree that someone who is hedging matching liabilities could find a good use for such a bond. However, it is naive to think that there aren't speculators buying what is a particularly volatile sovereign debt instrument when central banks have suppressed yields so much. Same goes for those buying Italian and Greek government bonds of much shorter maturities.

If it goes well and the yield falls from 0.88% to 0.38% then they indeed make a 46.8% gain. The previously issued Austrian century bond is sitting on a much larger gain than this. I have no doubt there are hedge funds and other trend following speculators that can't resist a punt like this. Some of them were caught out in March as even the US government bond market locked up at times.

The argument about reinvesting capital is fine on a short and medium term time frame, but it becomes problematic if someone is selling down their assets to fund their retirement. For this group, there's a choice between taking duration risk or credit risk to get additional yield. There's no free lunch, central banks are determined to forced people to spend their savings and will punish them with negative real interest rates to make it happen.

This comes back to the underlying point of the article. Central bank policy is badly wrong. The speculation on these bonds and other volatile assets is merely one impact of it. Eventually (perhaps decades away) people will realise that more of the drug makes the situation worse and decide to stop taking it. When that happens, there will be substantial changes in many asset prices, not just long tenor government bonds.

Thanks again for the detailed response.

 

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