The Folly of Investing in 50-and-100-Year Bonds
Benjamin Graham once wisely observed that more money has been lost by investors “reaching for yield” than stolen at the barrel-end of a gun. During periods of anemic interest rates on fixed-income securities, bank deposits, and cash equivalents, a combination of impatience, action bias, and desperation causes savers to do what they would otherwise consider extraordinarily foolish. What is more astonishing is that not only do they commit these economic transgressions, they do so with unabashed glee, clamoring over themselves to make sure that they, too, can be put on the list for what amounts to all-but-guaranteed misery down the line.
Those of you who have been paying attention to the debt markets in Europe have had a front row seat to the latest generational manifestation of portfolio management folly. Spain, Belgium, Ireland, and France have decided to take advantage of yield-starved investors – and, to the credit of the bankers and bureaucrats, in doing so, served the taxpayers well – by issuing so-called “Methuselah bonds” with maturities ranging from 50 to 100 years. Italy, it should be noted, is considering doing the same thing. I’d be surprised at this point if they don’t. The demand is there.
Misguided investors have lined up, shelling out tens of billions of Euros, for the chance to go long the currency on what promises to be a multi-generational span. That, whether they realize it or not, is precisely what they are doing. When you buy non-convertible, plain-vanilla, fixed-rate and fixed-maturity bonds not backed by a tangible commodity, guaranteed inflation-adjustment, or some sort of inherent spending control such as the constitutional provisions found in Switzerland, you are going long the fiat. Likewise, when you borrow under the same terms, you are are effectively shorting the currency.
Some of these deals were private placements. There are a handful of cases where they can make sense. One involves a phenomenon that we’ve touched upon in the past called asset/liability matching, which is when an insurance company has a future fixed-currency payout that must be paid on a specific date and it wants to ensure that pile of money is there at the time the payout must materialize while enjoying some yield in the meantime. Nevertheless, were I running an insurance company at these prices, at this time, under these conditions, it would not be something I’d be doing. Insurance is a game of probabilities and the probabilities are overwhelming, in my estimation, that the buy-and-hold owners of these bonds are going to get absolutely soaked in terms of purchasing power loss. I see almost no series of events in which a nation like Spain is capable of controlling its ultimate inflation rate by an amount that allows the after-tax bond yield to exceed that which is lost to currency depreciation. The pain for bond investors may not happen next year. It may not happen a decade from now. It will most likely happen. By writing the proverbial check for these fixed-income holdings, they are effectively transferring their purchasing power to the politicians and taxpayers of the issuing nations. It is unbelievably moronic. The wealth destruction of the private enterprises acquiring these securities will be entirely, utterly, and completely earned. In fact, I’d go so far as to say that any portfolio manager acquiring them should be summarily fired as I consider it a breach of fiduciary duty. Economically, it would be better for owners to suffer the consequences of negative rates and short-term losses. It elevates accounting performance over economic reality.
Thus far, this financial madness seems to be isolated to Europe. (There was a point at which, last year, Nestle bonds, which are so highly rated due to the sterling balance sheet that backs them, traded at negative yields, meaning investors were guaranteed to lose money. They bought, anyway, on the theory it would turn out to be a better deal than the risk of negative rates on cash and as a safe haven should the world go into recession. When an event like that occurs, the bond ceases to be a traditional bond and the negative yields becomes what amounts to a de facto insurance policy, the cost being comparable to a premium that owner is laying out for peace of mind.) Here in the United States, by way of contrast, you can get a nice block of something like an A- Rated ConocoPhilips bond with a 10-year maturity at a yield-to-worst of 3.7% or more. Meanwhile, you can buy Nestle’s common equity in Switzerland and enjoy a yield of roughly 3.1% with a high probability of future increases over time but for which you must be willing to risk the potential drop in quoted market value of 30%, 50%, or more, perhaps for several years. Frankly, well-financed insurance companies with rock-solid balance sheets would be better off buying blocks of Nestle common shares as a hedge to their long-term obligations but it would only work if they had a near zero-chance of needing to come up with a lot of money quickly in the event of an unprecedented catastrophe so a Great Depression-level collapse in the market value was little more than a notable line item in the annual report. A firm like Berkshire Hathaway could pull it off because it writes only about 1/3rd the premium volume its balance sheet could support and it has hundreds of other cash streams not related to insurance that are bringing in money capable of filling any liquidity needs but, otherwise, there aren’t many enterprises in the industry able to do what actually makes sense given their structural inadequacies. This is one of those areas where an intelligent, affluent, private investor who runs his or her financial affairs with the utmost conservatism has a major advantage over enormous institutions assuming, of course, they have nerves of steel and can focus on intrinsic value not the numbers on the statement that arrive from their custody agent.
This leads to an interesting moral dilemma. A firm like Johnson & Johnson, one of the few AAA-rated enterprises on planet Earth due to its business model and extreme conservatism, is taking advantage of this situation and issuing long-maturity bonds; longer than has ever been customary or notable in the United States. In effect, this all but guarantees that, over time, this bluest of blue chip will be able to arbitrage time and inflation, effectively transferring purchasing power from the lenders who buy their bonds to the owners who hold the common stock. That means they are issuing securities that must, almost by definition under nearly all economic scenarios, result in long-term harm to their owners. We can make the argument that the bond investors must be trusted to do what is right for themselves – that, perhaps, they anticipate we will enter a 1929-1933 scenario and the bonds will temporarily result in a windfall due to the resulting deflation – but even still, it seems like an awfully convenient excuse to do harm. Still, many people are comfortable owning tobacco shares under the theory they will provide whatever a customer wants, even if it means the customer’s own destruction because they value the benefits of their addiction above the drawbacks, including early death, so perhaps this is the world in which we reside; an inescapable part of human nature that cannot be avoided. Still, there’s something about it that, while I applaud the genius behind it, and am inclined to think even I may float such an issue were I the CEO of a place like Johnson & Johnson, gives me pause.
Therein lies the paradox. Nothing could be better for U.S. citizens as a whole than if the Treasury Department could refinance the entire national debt on 50 to 100 year maturities at historically low rates almost guaranteed to be depreciated away through inflation. But who is on the other side of the transaction? Such a thing might be fine if bought by the sovereign governments of other nations under the theory “we protect our own citizens first”, I suppose. Had the Federal Reserve followed such a policy back in the early 20th century, rather than attempting to help Europe, it is entirely plausible the 1929-1933 crash wouldn’t have happened in the first place as the lowered interest rates meant to ease the pain of our brethren over the pond wouldn’t have materialized in an attempt to stave off the capital drains they were experiencing as money flooded into American securities in chase of superior yield. Of course, this is, to some degree, grossly oversimplifying matters but it certainly seems to have played a role.
Personally, when making fixed-income selections for my own family members, particularly corporate bonds held in tax shelters, I find myself most comfortable these days with trying to target a weighted average maturity of somewhere around 7 to 8 years. I might buy some 3 year bonds and maybe a select few 15 year bonds as I start aging in a bond ladder but really, that seems to be the trade-off spot at which I feel I can maximize risk and reward. These days, bond inventories are so unappealing I find myself often glancing toward 12-month FDIC-backed broker-traded certificates of deposit yielding a guaranteed 0.75%. This is not exactly cause for glee. I remember the days when parking cash in a brokerage account yielding 5% to 6% from the money market sweep that was attached.
In the end, I blame the central bankers of the world. They have become so obsessed with attempting to avoid pain that they won’t do what is necessary for the system, and general fairness, in the long-run. They remind me of the enablers on television shows about addiction like My 600 Pound Life, These people reach gargantuan size, are unable to leave their homes, and yet still consume 8,000, 10,000, 12,000 calories per day because their husband or wife, child or sibling, parent or friend continually runs out and buys them obscene amounts of food. “I didn’t want to see them suffer,” they whine to the doctor when trying to justify that they are the ones delivering the mechanism through which the patient is committing suicide. This pain-avoidance is not good for civilization. It has consequences. Retirees who did what they were supposed to do now find themselves earning $20,000 or $30,000 a year on their passive income, not the $60,000 or $70,000 which market-rates would likely have given them. Debt bubbles get inflated in places like student loans and housing. Again, it’s more complicated than that but it does play a role.
For the enterprising individual investor, this doesn’t matter so much because there are always intelligent things to do; opportunities that are out there even if you have to create them.
It’s times like this, though, that you can really get insight into how people misunderstand risk. Someone will buy something like the Spanish bonds, with their 3.48% yield and maturing in 2066, over buying a block of Coca-Cola, which offers a 3.06% yield and has increased the dividend rate every February for 54 straight years, often at a clip that comfortably exceeds inflation. Given the choice, I would gladly put 100% of my net worth in Coke’s common equity, even suffering 90% paper losses during a Great Depression, over putting it in a diversified collection of 50-to-100-year European sovereign bonds at 3.48% yields. It’s not even close. I’m convinced that the probabilities favor a far better outcome in Coke than they do with the sovereign debt. Of course, such extreme allocations aren’t necessary or even advisable for success but it should give you an idea of how strongly I feel about it.
What’s the point of this late afternoon stream of consciousness? Learn to sit on your hands. When others are reaching for yield, don’t give in to the temptation. It’s better to earn nothing on your money than to do something stupid. There’s an element of seasonality in life. Sometimes, there’s a season for rest when not a lot gets done. For cash and cash equivalents, this is one of those times. Deal with it, do the best you can, and move on until it changes. Do not lower your standards in an attempt to make something happen because it will only end in pain.
Under what conditions would I consider owning 50-to-100 year bonds?
- The interest rate would have be far above the historical yields, adjusted for any subsequent structural changes that make past comparison inappropriate, and considerably above the long-term inflation rate (ideally, you’d be looking for a situation like the early 1980s when you have long-term rates at 3x the historical inflation rate while not confronting any sort of catastrophic fiscal emergency so a reversion to the mean was possible).
- I’d need to be convinced there was something in the works that could result in interest rates falling precipitously, including something like the introduction of a so-called Swiss “debt-brake” or a change in monetary policy.
- The issuer would have to be rock-solid so that I could be reasonably assured of recovering the initial outlay from interest alone over no more than 8 to 15 years. Ideally, as much of this would be placed in tax shelters as possible, including retirement accounts, private foundations, or certain types of controlled financial institutions.
If the stars were align under such a scenario – something that tends to only happen once every century or two – and I had faith in the policymakers to restore sanity to the interest rate environment, I’d probably consider putting up to 25% of my personal liquid net worth on the line as the chances of getting back a large portion of it in the front-loaded years were high enough to mitigate a lot of the risk while the chances of being right were satisfactory enough that I had an attached lottery ticket that could result in a windfall. It’d be a case of probabilistic tilting. Should everything go wrong in a remote-probability disaster event, there’s a good chance other sources of cash flow and investments could plug the subsequent hole in the years that followed with no effect on my standard of living.
Of course, all of this changes if we are discussing something like a hybrid security with an attached conversion privilege as it completely alters the math. I’d buy a 50-year convertible Coca-Cola or Johnson & Johnson bond at the right price almost any day for my retirement accounts. They don’t exist but should a handful of firms ever be foolish enough to issue them, I’d consider snapping a few up when the world fell apart, as it is prone to do occasionally.
Again, this is one of those pieces like my essay on market timing, valuation, and systematic purchases in that it doesn’t have a real point other than me thinking, or typing, to myself. If I could get really good, 10-year corporate bonds at 8% yields at the moment (as well as municipal bonds trading at a tax-equivalent adjusted yield), I’d probably have a quarter of my assets in them. The fear of the central banks has effectively destroyed much of the appeal of an entire asset class. It’s also created some significant distortions elsewhere. Most utility stocks terrify me at the moment. They are trading far in excess of what their risk-adjusted intrinsic value should be. Folks flock to them as fixed-income replacements and this is what you get. But you do what you do and adapt. You seek to avoid doing dumb things, protecting the wealth that was acquired over a lifetime of work. As an investor, you just have to deal with this. It’s at least preferable to the late 1990s. When I started investing, I could hardly find anything to buy.
Reader Comments (24)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
Jeff
May 11, 2016
I'd love to hear more about the reasoning / thought behind bond purchases for your family members. I have a hard time wrapping my head around buying a bond with a yeild the same as the dividend. Is this for (much) older family members?
For these yeilds I'd rather sit on cash and wait for something exciting to happen.
Side note: I was looking at blue chip bonds and saw some DIS bonds maturing in 2093!
Joshua Kennon
May 11, 2016
Replying to Jeff
Bonds play an important role in portfolio construction beyond the interest income they generation, especially with certain investment mandates. Part of that is reducing the timing risk of 1.) short-term market volatility 2.) the business cycle, and 3.) cash flow needs. It may be easier to illustrate using a hypothetical.
Imagine that you are 62 years old. You plan on retiring at 67. You have $500,000 in your retirement portfolio. You earn $50,000 per year. You and your spouse expect to collect $3,000 per month in Social Security income starting at 65 and you have a modest pension of, say, $1,200 per month that you can also begin taking at 65. Of that $500,000, virtually all is parked in traditional tax-deferred investment accounts such as a Rollover IRA, funded from past 401(k) balances.
When you hit 65, you could begin piling up the $3,000 per month + $1,200 per month from the pension (you'd need to take out taxes) in a brokerage account. You don't need the money, yet, because you are still working. In the meantime, you want to keep as much of that $500,000 as you can in your tax shelter because you don't have to pay taxes on the income inside of it. However, as you can't take the risk of a 90% collapse in equities like 1929-1933, or a 50% to 75% collapse in equities like 1973-1974, investing the entire balance in stocks can be foolish absent some unique circumstances. When you go back and look at various portfolio asset allocation mixes, the historically ideal trade-off assuming a normal life expectancy, in my opinion, is a roughly 1/3rd weighting in fixed income securities with it put to work in a way that there is always cash coming up for maturity so you can throw the freed funds far out on the maturity cycle at the maximum interest rate you can get (assuming an ordinary yield curve). It takes some time to work into effect but, under present conditions, you could basically always have money freeing itself up while earning a tax-free 3% or so on the fixed-income component, at least keeping pace with inflation. The other 2/3rds can be in a widely diversified collection of blue chip equities yielding a weighted 3% per annum or so.
The result is you end up with $15,000 in cash income per annum, none of which is taxed but that, instead, piles up cash until you put it to work. If a 1-in-600-year collapse occurs, not only are the bonds, which are constantly maturing, providing you cash at a time when we're likely experiencing deflation, meaning their purchasing power is increasing assuming you've selected high enough investment grade, but you have the government benefits and pension cash accumulations in that brokerage account (which, if you wanted, you could use to buy FDIC insured short-term certificates of deposit).
Even if you were laid off, assuming you had wisely managed your personal balance sheet and had little to no debt, it'd be very hard to go broke or suffer a substantial decline in your standard of living under such circumstances even if your accounts were down 30% or 50% on paper. You wouldn't be forced to sell your ownership stakes in wonderful businesses to fund your lifestyle as the bonds and cash form a wall that protects them.
Trying to chase the theoretical 7% difference that has historically existed between bonds and equities over long periods of time when you don't have long periods of time to ride it out based on your cash demand needs could be mathematically disastrous. To borrow a phrase, our hypothetical investor would be risking what he or she had and needed for money that he or she didn't need; extra that isn't going to have a whole lot of utility compared to the dis-utility of a non-favorable liquidity demand.
We will see another 1973-1974 at some point. It will happen. I'm willing to wager that when it does, there won't be any warning. Prudence demands being prepared for it. Now, if you're 30 years old, this degree of safe harbor is probably not necessary and may even be non-desirable. The best thing you could do would be to pay off your debts, store up cash, and maybe get some cash generating real estate underneath you that is strong enough it could survive a severe and extended recession or equity-market collapse. The trick is making sure you're positioned to not only survive it, but take advantage of it (the investor in our scenario, assuming living standards weren't at risk and job employment was secure, could use those bond maturities to buy stocks at once-in-a-generation pricing were they so inclined) while also not locking yourself in so long that the materialization of a highly inflationary environment starts to erode your purchasing power.
Like clockwork, though, you'll see older investors completely shun bonds following an extended rise in equity prices. They pay good lip service to long-term investing and whatnot but time and time again show they are either forced, or choose, to sell out as stock prices collapse. Then, they'll hug bonds like the best thing in the world, refusing to buy stocks when everything is terrifying and stocks are most attractive. I've watched it play out three times in my lifetime thus far, and seen it in the history books going back to the 19th century, at least. Human nature doesn't change.
The bonds allocation wouldn't be necessary, of course, if you had some sort of rock-solid bond-like replacement. If, for whatever reason, you were collecting $40,000 a year from an annuity or perhaps even a public pension on top of your Social Security benefits, it may be perfectly sound to go ahead with a 100% equity allocation on the theory you'll never need the money under almost all scenarios and you want to leave the most wealth you can to your heirs, who will inherit the stock and take advantage of the stepped-up basis loophole.
At least, that's how I look at it. It comes down to portfolio management, which is a separate but related discipline to individual security selection. Getting the portfolio risk right is a big deal and extremely important. But, otherwise, I wouldn't be locking up large amounts of cash in bonds if I were relatively young, had little to no debt, a large and stable income, and at least 50+ years of life expectancy. Not at these prices.
Take that for what you will. This is all just academic, of course. I can't give you any specific advise or tell you what you should be doing.
Scott McCarthy
May 12, 2016
Replying to Joshua Kennon
Your illustration makes no sense. The Social Security benefit and pension that you assume works out to be more than the hypothetical guy's salary. And the Social Security benefit that you project would require both spouses claiming it, if their household income was $50k ... and you can't do that while still earning a salary of $50k.
Really, the only thing the portfolio is good for is offsetting a potential decrease in purchasing power of 28.5% of the household's income if the pension isn't indexed to inflation, and leaving an inheritance. If they're actually going to use the income from the portfolio, they could retire at 65 (not 67) and enjoy a roughly 40% increase in their standard of living (assuming they're living paycheck to paycheck; if they're saving, it would be even more).
Joshua Kennon
May 12, 2016
Replying to Scott McCarthy
it does, you just don't have all of the details. (When writing, I find myself performing a balancing act, to once again quote economist John Kenneth Galbraith, that recognizes "there is also a line between adequacy and pedantry" in giving details. It's not exactly a great use of time preparing details Excel spreadsheets and PowerPoint slides when a quick answer will suffice and carry 99% of the water.)
The numbers based on an actual older couple I know with a fairly heavy fixed income weighting. These two, for many years, had a higher income than their present salary but one was laid off resulting in a drop right to the present $50,000 income, which is not indicative of the lifestyle to which they are accustomed or that gave them their promised future payouts. The pension is not a lifetime pension but, rather, has a fixed number of payments that does not adjust for inflation and that, within about a decade of retirement, will go to $0. The spouse that will receive it is lucky because they were one of the last folks to get on even that limited pension plan before it was phased out decades ago. One of the spouses has a very, very high probability of living an additional 30 years after retirement given family history.
To mitigate all of this and ensure they don't run out of money, they have a fairly complex timing schedule built so that the moment they can claim full Social Security at the retirement age (you are correct they can't do it while 62 while earning their income but they aren't far time wise from being able to do it; they plan on working for as long as they can and claiming those benefits once both spouses cross the eligibility threshold which, given they are almost exactly the same age, isn't a problem), they plan on doing it while allowing a mix of equities and fixed income to compound for as long as possible in the tax shelters. They will continue working for as long as they can, even it means being door greeters at Walmart, avoiding spending any money from either their benefits, (limited) pension, or retirement savings so that when they finally quit, by choice or involuntarily, and the pension stops, they have enough capital from the reserves they've built so one or both of them could survive for 30 years with no labor income at all.
They had me review it for them to make sure they hadn't made any math errors; to give them my estimation of the chances they would ever fall below a certain level of monthly cash flow, adjusted for reasonable inflation expectations, if they were forced to begin living off it at some point in their 70s. It was very well done. It made perfect sense for their unique risk factors, concerns, and circumstances.
People's career paths are funny. The terms of their individual pensions are funny. Their annuity contracts, when they exist, are funny. The concept of truth being stranger than fiction is certainly no stranger to personal finance. I've seen it far too many times. Not everyone's retirement plan looks like it came out of a CFP workbook with a long career of ever-escalating earnings followed by a gold watch and a party. The numbers may not look like they make sense on the surface, or fit with their present facts, but then you dig in and find out there was divorce of inheritance, career change or lawsuit settlement. Life's messy and the numbers reflect that.
Joshua Myers
May 12, 2016
Replying to Joshua Kennon
Do you factor in duration and reinvestment risk when you're building bond portfolios, or do you always plan on holding for the entire life of the bond?
Joshua Kennon
May 12, 2016
Replying to Joshua Myers
My primary, overriding concern is "yield to worst" - be that maturity, involuntary call, involuntary conversion, or whatever else could trigger the end of the bond as it is presently structured. Then, with few exceptions, I say hold it until it either matures or the trigger event occurs. Even if we were to enter a period where fixed income opportunities were abundant on a value-basis, that YTW, and the underlying soundness of the obligation, would be the margin of safety. Whether I chose to sell early to redeploy funds elsewhere or not wouldn't matter as I could calculate my maximum theoretical gain in a lot of cases except those rarer situations where equity conversion is somehow attached.
Joshua Myers
May 15, 2016
Replying to Joshua Kennon
That makes sense from a margin of safety standpoint, which should probably be the most important factor. Thanks.
Jeff
May 15, 2016
Replying to Joshua Kennon
Thanks for a great response! I am going to summarize what I see as the lessons here, both previously known to me, and what appears new.
The first is a Joshua Kennon Iron Rule: 'Never let anyone force you to sell an undervalued asset, especially in a crash'. This makes total sense, and I've known this for a long time. I just thought that having a big cash cushion and being able to live off just dividend income seems to meet this requirement well. But your suggestion is making me think that maybe having some bonds anyways is a good idea, and it may be *critical* if you don't have enough other income.
This also makes me rethink the security of dividends. I just checked, and the S&P 500 dividend dropped 22% in 2009, and didn't recover until 2012. Ouch. (http://www.multpl.com/s-p-500-dividend/table)
Back to the example at hand. As these people will be retired you say they need a 'wall of cash and bonds to draw income from when they absolutely don't want to sell their equity assets'. The bonds is the new part for me.
Here's where I think I am learning something new: You are suggesting that the *maturation* of the bonds provides cash to spend where you are guaranteed the ability to 'sell' your assets 'at original value'. In other words, bonds give you the *option* to live off the return of principal at a fixed value, not just the coupon. You trade off the lower yield and reinvestment risk for the almost certainty that you get the principal back at set times in the future to spend at your option. Assuming a 7 year long bond ladder, $170,000 / 7 = $24,285 income a year to bridge 7 years of a horrible stock market.
Did I get the lesson right?
My follow up homework is to learn if this maturation trick works the same in a bond *fund* as with individual bonds. Googling seems to indicate there is an option of fixed maturity bond funds with target years.
Thanks!
Note: Single quotes used to show that I am paraphrasing in a way I believe to be honest to the original writings.
innerscorecard
May 11, 2016
Welcome back! Classic Joshua Kennon: Clear explanation, and embedded incidental scorching tirade against societal evil that could be a separate entertaining rant.
Taking out a mortgage = the only way to profitably short long bonds?
Roundball
May 11, 2016
Welcome Back! This inspired me to go back and read your old post from 2010 about shorting the dollar by taking out a mortgage. It went completely over my head the first time I read it, but seems much clearer to me know. Amazing how knowledge compounds over time.
Any good finds at the Berkshire bookstore this year?
Muhammad
May 12, 2016
Joshua, I dont see the small note telling us that the site is under construction any more......I'm assuming the site upgrades are complete? Also, I like the new look !
Joshua Kennon
May 12, 2016
Replying to Muhammad
It is still very much under construction but part of that is removing the sidebar where the notice was. It will take a few months to get through all of the back posts and convert them. For example, as of today this older page has been converted, while this older page has not. The menus at the top are still broken, too, but we are a lot further on the upgrades than we were a couple of weeks ago so they are coming along.
I'm glad you like the new look! Personally, it's my favorite out all of the themes the site has ever had. I can't wait for the work to be done when all of the features are rolled out - there are different pre-made templates that can be used for different purposes. For example, if we ever do a Podcast, we can have Podcast or video galleries that look like the blog post listings. It's really cool. It makes me happy to work on the site, again, whenever I can grab a minute here or there.
Eric Vaughn
May 12, 2016
Replying to Joshua Kennon
I love the new format - really like the white letters on a dark background. While you're discussing other mediums, have you considered doing YouTube videos? Maybe discuss the day's financial events while drinking a Nespresso in front of the fireplace?Just a thought.
E
Muhammad
May 12, 2016
Joshua what do you think about using "riding the yield curve" strategy here? If i remember correctly the strategy entails buying bonds with maturities longer then the investment horizon (from the investor's perspective) but the requirement there is that the yield curve is upward sloping and the investor expects the expected stop rates not to change (remain flat). I'm asking cause the capital gains could be huge given the 50-100 year maturities as the additional risk premiums for interest rate risk on these bonds would be MASSIVE!
Matt
May 12, 2016
I agree that buying long duration bonds is a very bad bet at current rates. You'd have to be betting that long-term inflation will be relatively benign over the next few generations, which is unlikely, in my view. Though it seems like a Japanese style deflation isn't out of the cards, 50 to 100 years is a LONG time to wait. And even then, 3.5% yields don't seem appealing, given that there isn't much room for yield compression like there was going from 15% interest rates to 3%.
With that said, I don't think its entirely fair to blame the Fed for the current interest rate environment. What is essentially happening is that fixed income is simply getting destroyed relative to equities, and people and the rewards for being a bondholder is simply less appealing compared to being an equity holder. But do bondholders really have a reasonable expectation of higher returns, or were the good returns from bonds in the last 3 decades an anomaly? There really doesn't seem to be any logic that says that bondholders are being "robbed" of income unless you assume that the high interest rates are a God-given right. And historical real bond returns don't seem to suggest that there is some "natural" rate for real bond returns.
Like you imply in your criteria for owning long-dated bonds - the bonds don't become attractive because the nominal interest rate is high. They become attractive when you believe that those rates are both abnormal and unsustainable, and that mean reversion will boost your returns above what could be expected simply from extrapolating current inflation/interest rate trends. I agree that this is how you should be looking at the attractiveness of long-term bonds, but I don't think that long term are something that the average investor should be dealing with, as it does require a strong opinion about the mean reversion of inflation/interest rates, which is a much less certain proposition than the mean reversion of real equity returns.
Jeremy Siegel himself notes that over long periods of time, real equity returns seem to hold constant at 6.5-7%, while no such consistency can be seen from fixed-income investments. I think it's fair to debate whether it is good policy to lower interest rates and effectively increase the inequality between risk-takers (who can afford to accept the volatility of equity investments) and the risk-averse investors (who cannot afford to increase their equity exposure since they require the stability of bonds to fund their lifestyle). But the accusations against central bankers ignores the fact that the Fed can really only manipulate interest rates within a realm of reason. If "artificially low" interest rates caused an increase in the demand for dollars, then the Fed would be forced to increase rates to slow the boom and avoid high and rising inflation. The fact that we've been in a low interest rate environment for the past decade in the presence of disinflation suggests that the boom isn't coming.
Now the alternative criticism is that the low interest rates are distorting the economy and creating instability in the system by increasing leverage and making people complacent to risk. This may be true for those purchasing 50 year bonds, but in aggregate, low interest rates don't seem to be fueling a debt binge. The Fed data on household debt shows that household debt growth is at its lowest it's been in the past 65 years, and that overall household liability levels have barely changed in the last decade in nominal terms. Of course, that means that relative to the economy, household debt to GDP has decreased from 100% to 80% over the same timeframe, which should be welcome news. Some of this debt has simply been shifted to the corporate and government sectors, but that doesn't change the fact that the public + private sector has had the slowest debt growth that we've had in a long time. Low interest rates just don't seem to be sending people into a mania, and we both know that student loan growth and the housing bubble were both fueled by more than simply low interest rates.
At some point, I think this comes down to reasonable expectations for fixed income investments. Due to the globalization of financial markets, I think you can argue that the period of high returns for US government debt is over. Despite significant economic progress in other parts of the world, the US is still the safest place to park your money, and that leads to competition from foreign investors. Everyone wants to own US government debt, not for its income, but for its safety. You can see this from the fact that US government bond yields decrease with financial instability as people rush towards "safe" assets. Clearly, there is a demand for these bonds despite the low interest rate. Buying these instruments for yield is a mistake, but that doesn't mean that bonds have no role in your portfolio. Maybe this just means that we're looking at a world where the role of bonds is changing. US government debt is becoming the world's savings account (piggy bank with slightly lower liquidity but higher interest rates). Maybe we have to get comfortable with the fact that we may not be able to earn the same real returns from the bonds as in the past. Sure, there will be times where we will be able to capitalize on rising yields due to inflation or other fears. And you should definitely maintain discipline instead of reaching for yield. But building a portfolio thinking that you can rely on bond income to retire may simply be unrealistic looking into the future. I don't think that we can reasonably blame the Fed for the fact that retirees aren't getting the fixed-income returns they were expecting.
Like you say, there's always something intelligent to do. If the spread between fixed-income investments and long-term equities were so big, then we might be seeing a higher demand for annuity type instruments that could help facilitate the duration mismatch. Obviously that has its own problems and comes with drawbacks, but it's not an unsolvable problem.
Joshua Kennon
May 12, 2016
Replying to Matt
This is one of my favorite comments in a long time. Thank you for taking the time to write it.
Siegel's research on fixed income securities, in particular, is interesting to me. When you go back and look at the experience on an after-tax, inflation-adjusted basis, it becomes clear that investors did not modify their return demands when the U.S. left the gold standard. Bonds, which had generated real, positive returns as an asset class more often than not when on the gold standard (which was still terrible if you wanted to avoid things like horrific deflationary environments so I'm not advocating for it by any means), suddenly failed to do so unless you were buying them on a value-basis or during periods where you wanted to make interest rate bets, using longer maturities as a way to take advantage of anticipated declines in rates. This would indicate that the average fixed-income investor did not internalize the fundamental shift that occurred when the currency became completely detached from any sort of constraint other than the will of politicians. The only reasonable conclusion is that fixed income investors, as a class, have perpetually overvalued bonds by demanding an insufficient rate of return since the loss of tangible backing in the currency. At this point, I'm entirely convinced it is due to something that famed economist Irving Fisher referred to as The Money Illusion; a cognitive bias that causes people to think about prices in terms of nominal currency instead of purchasing power, leading to irrational allocation decisions. Curiously, generation after generation, these investors never seem to catch on to their mistake. Not as a group, anyway. In other words, the nature of bonds changed. They aren't the same instrument, anymore. You can't simply acquire them throughout life and expect to do well the way you once could, broadly speaking.
In that regard, you're right. Fixed income investors certainly haven't needed the Federal Reserve's help in accepting sub-optimal deals. They are perfectly content to go ahead with them even in benign environments. Equities have benefited from this tremendously, of course; in a real way, things like Johnson & Johnson's long-dated bonds are transferring purchasing power from the bond investors to the stock investors in the form of a lower cost of capital. That said, I still think the Fed can be blamed for making the situation far worse than it would have otherwise been. I'm firmly in the camp of Esther George, president of the Kansas City regional bank, who advocates for returning to higher rates; that the Federal Reserve cannot, and should not, try to manage every blip in the financial markets. There are non-intended consequences and it perverts incentive systems. (And, yes, I wholeheartedly agree with you that things like the student loan debt market aren't entirely due to the Fed but to other forces, including certain government policies, that effectively inflated a bubble.)
I think, broadly speaking (and certainly beyond the context of the Federal reserve and long-duration bonds, in any case), a major concern I have is this: As the industrial economy has given away to the knowledge economy, and Peter Drucker's predictions about the role of low-skill labor have materialized, we have moved to a hyper-competitive, individualistic, do-it-yourself economy that shrugged off many of the safeguards put in place during the 20th century; the guardrails that kept society moving. In many ways, this is ideal. Capitalism is vastly superior to Socialism and other systems in terms of delivering standard-of-living increases. If the typical American family suddenly had the living standards of some of our affluent allies - say, Sweden or Ireland - there would be riots in the street. You'd think we'd be living through another Great Depression. (Seriously, it's always a lot of fun to watch someone from Europe talking about American "poverty" suddenly realize that, by some governmental definitions, a married couple with two kids is considered impoverished with household income of $44,000 per year. Comparably, our poverty is largely their middle class. Discretionary income, home size, vehicle preferences... our baseline standard is so far above most of the world, it's obscene and it's only more so now that intellectually dishonest politicians have begun defining things like childhood poverty as a relative metric, rather than an absolute one.) For people with a great work ethic, entrepreneurial spirit, and high analytical intelligence, this can be a windfall. You can practically print money with nothing but an Internet connection; find suppliers around the world, launch a business, create a software platform, write and distribute novels collecting 10x the proportional share of revenue as your predecessors; it's a winner-take-all system made possible by technology.
Even in things like equities, people like me have all of these wonderful opportunities. I can sit at home, in my pajamas, and search the world for intelligent things to do. I can find opportunities and plant financial seeds that provide harvests for years, even decades, to come.
What, though, about the guy who is 18 years old, who is willing to work hard, but who simply doesn't have the cognitive ability to thrive in this environment? He's being replaced by machines. His inflation-adjusted labor rate is holding steady or declining as everyone around him is showered with larger and larger amounts of affluence. He can't hope to keep up - he's never going to become a neurosurgeon or design a superior logistics system - so what is he going to do? In the old days, he'd have a pension. This is not a person with the capacity or desire to throw himself into 10-K filings. He didn't need to worry about which equities were supporting that pension check, it just arrived. The one thing he had going for him were decent yields on savings. From savings bonds - which the government began effectively gutting under President Bush and which has continued under President Obama - to money market accounts, all anyone cares about is the stock market. I'm not sure that's good for civilization. Perhaps a responsible monetary policy should include a mandate that rewards prudence and saving; that treats the asset class most valuable to the lower classes with equal respect.
I'm going a bit off course, though because these are more philosophical questions I have about the nature of the financial system we're building and maintaining; things I've been thinking about lately. (In fact, I recently had an older retiree write me genuinely upset about the fact that I pointed out someone who stuck to fixed income securities did not deserve, nor should they expect, the superior returns investors in real estate and equities enjoy. She took great umbrage with this assertion and gave me a piece of her mind. I still think she's wrong - equities and real estate should produce superior results in a just economic system that rewards providing utility to fellow citizens - but that's different from whether or not we at least attempt to respect cash and fixed-income securities as an asset class worth their own consideration in determining monetary policy.)
I need to get back to work. Thanks for giving me a chance to think out loud and leaving such a fantastic comment.
Ang
May 12, 2016
Not much I can contribute as Matt and Joshua have covered most of what I wanted to say, but I do have a couple of thoughts.
First, related to the inflation/deflation discussion, it's amazing to me what's going on - we can't print money fast enough to generate any inflation. Why do you think this is? Seems there are some different factors - having a stronger economy/growth than other countries, producing/using our own oil has led to a depletion of the trade deficit, more desperate money printing strategies abroad in Japan and Europe, a decreasing budget deficit, and the Fed money is rolling into financial institutions/housing. What are the chances that the next tiny little economic shock would send the Fed back to printing more money/possibly setting rates up for a deflationary environment? Though it really appears that there's a bond bubble now, on the off chance we have terrible deflation, the gamblers and speculators buying these long term bonds will have done okay. It does seem unlikely though.
Maybe the environment we are in, where rates are going negative/policies not generating the velocity of money expected is encouraging investors to buy these long term bonds because they continue to expect lower and then more negative rates? I think my main gripe with such capital allocation decisions is the length of time you lock yourself in for, without a good option to get out. Like Graham said, at what terms?
Secondly, your point about central bankers all printing money and investors crowding into yield stocks (utilities yes, but consumer staples are also overvalued across the board, while MLPs a year go and REITs now have also gotten the mom/pop treatment) just reminds me of how powerful social proof and consistency can be. Printing money hasn't much worked for any of the central banks so far besides propping up US equities (generating undesirable consequences instead), and a return to inflation and sudden movements up in interest rates would devastate the utility/REIT investors, but there's safety in numbers I suppose. If the lemming in front of you is going to jump, it only seems sensible that you should too.
I wonder how many investors know in their hearts that they're taking bad terms on these bonds, but worry they will be judged if they don't do the same thing as the manager two streets away. I also wonder how many investors do curve fitting to convince themselves that bonds will always be safe - we haven't had an increasing rate environment for over a generation now, I'm sure many people who focus on price charts only took a look at the turn of the century as well as 08-09, saw how well bonds held up, and didn't do the next level of thinking on WHY bonds held up.
Well, regardless, it will be interesting to see what happens
Jay Young
May 13, 2016
Replying to Ang
The headline inflation number has been tame, but looking at the split between tradeable, non-tradeable, and commodity prices tells somewhat of a different story. Tradeable good and service prices have been kept down for the same reason that they've been capped for a while - globalization is keeping competition fierce and prices low. Non-tradeable goods and services, however, have been rising fairly steadily, but have been keeping the average low due to the stagnant (or falling, thanks to the strong dollar) tradeable prices and the collapse in commodities and energy. Whenever commodity and energy prices rise again, that counter-balance is going to disappear and the headline inflation number could come running back up in a hurry.
One theory is that the modest wage growth we've started to see in the last few months, coupled with this apparent price ceiling is driving more money into savings and further inflating asset prices. The result being lower yields and expected returns, regardless of what the Fed does with rates.
Matt
May 14, 2016
Replying to Ang
I think part of the misconception is that quantitative easing generates inflation. First of all, the Fed isn't printing money. It is conducting an asset swap. The Fed is essentially stealing interest bearing assets from the private sector and replacing them with bank deposits. So by engaging in QE, the private sector is actually losing income, which could arguably be slightly deflationary. Of course, by swapping bonds for bank deposits, the Fed has also changed the private sector balance sheet. You can think of it as your savings account (lower liquidity, higher interest rate) has been replaced with a standard checking account. You now earn less income than you did before.
Now what about those bank deposits? Your economics professor might have taught you that the banks will now lend out these excess reserves and the money will multiply throughout the economy. But this is a mistake. First, here's the data on the Fed's balance sheet and excess banking reserves. As you'll notice, excess reserves seem to jump up by almost the same rate as the Fed's assets. Which means that many of these bank deposits aren't actually being lent out in the economy. And that's because the economists are getting it backwards - reserves don't cause demand for loans - loans cause demand for reserves.
A bank essentially earns a spread on the interest rate earned from outstanding loans minus the interest rate it must pay on its liabilities (including deposits). But bank's aren't reserve constrained - they are capital constrained. Having reserves is not a prerequisite for making a loan! This is because reserve requirements are calculated in an overnight maintenance period. Thus, the bank can make the loan and then can always borrow reserves later from other banks in the interbank lending market or directly from the Fed.
Suppose the bank has excess reserves. Will they be lent out? At the prevailing interest rate, if someone comes to the bank asking for the loan and they were credit-worthy, the loan would have been made regardless of whether the bank had reserves or not (the bank would make the loan go out and borrow reserves later if necessary). If the prospective borrower was not credit-worthy, the bank wouldn't make the loan regardless of whether or not there are reserves. So in both cases, the reserves are not a consideration for the decision to underwrite the loan. The only way the Fed can influence loan growth is by changing the "price" of loaning money (which would increase quantity demanded). But that's it - they can't actually force loans to be created. And if the loans aren't created, then the excess reserves aren't going anywhere - they are "trapped" in the banking system and don't multiply throughout the economy like the money multiplier effect predicts.
So in essence, two things are happening here. 1) The Fed didn't "print money", they simply exchanged interest bearing bonds for bank deposits. Billions of dollars of interest income left the system when the Fed effectively removed interest-bearing bonds from the private sector and replaced them with bank deposits. This effectively lowers private sector income, which should be deflationary. 2) The money multiplier theory gets the causation wrong. Demand for loans creates demand for bank reserves, not the other way around. If there is not enough demand for loans, they simply don't happen. Even if the Fed tries to stuff more reserves into the system - there is no transmission mechanism to get them out into the real economy. The fact that excess reserves have largely risen in tandem with the Fed's balance sheet size suggests that loan demand is weak. So the initial statement is wrong - money supply isn't rapidly expanding (excess reserves don't count, they're not in the hands of the public and are stuck in the banking system). Since the money supply isn't rapidly expanding, we shouldn't expect this to cause massive inflation.
Blair
May 13, 2016
Hi Joshua et al.,
Borrowing a phrase from Mr. Sowell, "there are no solutions--there are only trade-offs." Is the short-term pain you say that central bankers are avoiding by keeping interest rates so low worse than what we're seeing now with the 50- and 100-year bonds and inflated asset prices? Is it that the consequences of the current low-rate environment are harder to measure than the consequences of raising rates? (For instance, I think of the FDA not approving a drug because it would result in X certain deaths, instead of measuring the lives the drug, if approved, could potentially save.) I'm having trouble tying the macroeconomic factors to their ultimate effects, including the unintended consequences. If anyone can help me understand this I would be very happy.
Matt
May 14, 2016
Is increasing the interest rates the answer? Another alternative could be making social security more generous (funded by income, not payroll taxes). If we're going to argue that we should be supporting those who don't have the cognitive ability to thrive in this competitive environment, what about those who for whatever reason don't have the discipline to save? At what point is it society's fault, or the individual's fault? Pension funds in the old days couldn't be raided, no matter how much one might have been tempted to do so. It just wasn't possible. We now have a system where people always think that they can raid the IRA or 401k in an "emergency", and the law allows them to do it. Cognitively, taxes and penalties appear to be a small price to pay if they will solve your immediate short-term needs. We know that when people are in crisis mode, they become myopic, make sub-optimal decisions that fix the immediate problem at hand, and are blind to the future consequences. The problem with this system is that when people fail, they ultimately don't see how they sabotaged themselves - it was the system's fault. Of course, when this happens, it also seems unfair to ask the taxpayer to bail them out.
So what we have here is not so much a debate on interest rates, but a political and philosophical discussion on who should be responsible for outcomes and whether or not we are willing to pick up the tab for those who can't or won't act in their best interests. I agree that economic forces are definitely putting a certain part of the population in a tough spot. But I don't think this is a problem that can be solved in the monetary sphere. This is ultimately a question that must be solved in the political and legislative sphere.
Although people (especially on Wall Street) act as if the Fed is some sort of all powerful entity, the reality is that the Fed's tools are rather limited in terms of its ability to stimulate the economy. Congress is rather dysfunctional, so fiscal policy is off the table for the most part. And since people don't trust Congress to act, they're turning their eyes to the Federal Reserve to do something even if monetary policy is becoming less and less effective. I think that the Fed is getting caught in "do something mode" since they need to justify their existence (for the same reason why money managers keep trading frequently - they need to give off the appearance to their clients that they are earning their keep).
Jeff
May 15, 2016
Replying to Matt
I totally agree that much of the (inappropriate) focus on the Fed to "fix things" is because people have given up on Congress doing anything useful.
As far as things that could be done, I'm wondering if the government should make more simple guaranteed investment options available - Maybe a TIPS that always pays 2% more than inflation, but is only available in 10K a year increments and unable to be touched except under certain circumstances?
Clint
May 20, 2016
I learned more about bonds from this comment and reply than any other single piece of information I've ever read. People take books to explain what you just said in a few paragraphs.
I also now better understand the cognitive dissonance that arises when talking to older people about the role of bonds in a portfolio, somewhat similar to the message Josh received from his post on the long term cost of investing in bonds vs equity. The consequence of removing the gold standard wasn't immediately felt due to the long term decline in interest rates over 30 or so years, and now absent that factor, people are incapable of linking the event, decades removed, from a consequence felt today.
It's an interesting flaw in the usually very good pattern recognition of the human race that is played out again and again across the entire spectrum of experiences. It can be seen everywhere from crime rates in the 90s to the role a new technology will play in an industry i.e. Eastman Kodak.
Anyone know of any good research on the topic?
Northern_Dave
September 12, 2017
Just discovered this site today while pondering bonds (of which I currently hold...none! I am 100% in equities which I am targeting earning 25%/a on and am happy with my progress). Today, however, the 12th of September 2017, I have discovered the Austrian government is offering a 100 year bond at around 2.1% yield. I have avoided bonds because unlike in Grandpa's day when they could be a relatively safe way of earning a reasonable return - he used to get if memory serves 6% tax free, basically risk free which he used as a less risky than his delightful 20% a year increases off Canadian bank stock appreciation + dividend - current rates are sub grocery store inflation unless you buy uber-risky junk bonds (Venezuela....). From reading your blog I would assume you would consider this a bad investment. If the Prechterite disciples of Elliott Wave Theory are correct and we end up in a multiple decade global depression would such a bond redeem itself to some degree?
Many thanks for your explanations which, indeed are the clearest on bonds I have read.