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.