U.S. Treasury Reconsidering Ultra Long-Term Bonds

Ultra Long Term Bonds

Government issued bonds have traditionally had a maximum term of 30 years, but longer ones are coming into fashion. We might see some longer U.S. ones soon.

When we are considering purchasing bonds, one of the main things that we look at is the term of the bond. When we buy bonds, we lend money to the bond issuer, the U.S. Treasury for instance in the case of what we call treasuries, which is shorthand for the notes, bills, and bonds that they issue.

We lend the money by buying the bond, and in most cases collect interest payments on the loan that we have provided over a period of time, then at maturity the principal amount, the face value of the bond, is paid back to us as well.

If we buy a bond which matures in 30 years, some people invest that long out so this would seem to be reasonable for some people at least, those with that much time to be able to make this sort of long-term commitment.

That’s just about as long of a time horizon as people have though, so the idea of a 50 or a 100 -year treasury bond may seem, on its face at least, a crazy idea. This is especially the case with the 100-year as people don’t live that long typically even if they bought the bond from the crib.

Some countries have introduced 100-year bonds though, and the people who buy them do not expect to live to see it mature, but thinking that this point matters is at the heart of the confusion here.

Those who think of bonds as making loans that you need to be around to collect the principal payment and their just being used to earn interest will surely have their views shaken by the introduction of the German 31-year zero coupon Bund. This bond not only pays no interest, ever, it is issued at a price higher than its face value.

You lend the German government a certain amount of money with this, and they promise to pay you back less than you lent them in 31 years, interest free, provided that the German government still has the means to do so in 31 years. There’s always the possibility of default with any bond, and 31 years is a long time away, so you actually could walk away with just losing the amount that you spent on this with no recourse.

The fact that such a thing even exists should tell us that the way that we think about bonds is perhaps in need of revision. They had no trouble selling a billion dollars’ worth of these, and have even more of them in reserve should they wish to have people lend them more money for free and charge them 3.5% on top of the face value for the privilege of doing so.

If this were not bad enough, there is inflation to consider as well, and even if inflation remains low like it is now, you can count on losing at least half of your investment to that. There’s also the future discounting of money to consider, where a certain amount of money will be worth more to us now than it will in the future, especially 31 years from now, and we normally would need to collect more to make up for this, over and above the losses from inflation of course.

None of this ultimately matters to some people though, and these are not people whose goal is to hang on to these bonds for 31 years and redeem them. This is the case with 50 or 100-year bonds as well, and the goal may simply be to speculate on them, which is behind a lot of people holding bonds actually.

The 31-Year German Bund is on the extreme end of this though, or it is until we see something else even more extreme, but we could say that any bond that has a negative yield would fall into this class. The amount invested in negative-yielding bonds just keeps growing as the year moves on, where we’re now up to about $17 trillion’ worth of this paper and counting.

Adding a Lot More Time to Treasury Bonds Actually Makes Sense

While negative yielding bonds in Europe has become the norm, U.S. treasuries have always offered positive yields no matter what has been going on, and they also always pay interest. It is possible that the market may bid up the price so high and the coupon rate on further issues can sink so low that we do end up in negative territory yield-wise, but we’re still a long way from that and we may never actually get there.

50 and 100-year treasury bonds are a distinct possibility though, and the Treasury is revisiting the idea. They proposed this a couple of years ago, but bond dealers gave them so much push back that the idea was scrapped. The temptations of this are re-emerging now though.

Bond dealers do have a lot of say in this because this is who these treasuries are placed with, in other words, these are the clients of the Treasury, who sell them the paper and the dealers then place them in the market. This is not unlike an IPO where shares are sold to institutional investors, and with an IPO it’s important to keep these people happy so that they can move the shares, and the same is true with bond auctions.

Dealers still don’t like the idea of bonds this long out, including JPMorgan, who is encouraging the Treasury to focus more on the 20-year instead. JPMorgan does not think that the demand for the longer ones will be sustainable, and while they may actually be right, the Treasury doesn’t care that much about these things because once they issue bonds, they get paid and wherever they go in price from there doesn’t involve them anymore.

The longer the term with a bond, the more time we have to not have to deal with maturities, and that can be a good thing. We can look again at negative-yielding bonds to get a sense of why.

Let’s say we buy the 31-year Bond at its issue price. The goal would be to hold it for a while and sell later, at a higher price, and there is no other strategy here because we surely don’t want to hold it until the end.

These bonds will suffer from time decay though, sort of like options do. If we move the clock forward to a day before the expiration date, at this point there will be no time left for it to rise in price, and no reason why it would because tomorrow it will be worth face value, which would be what it would be worth then.

As we move closer and closer to that day, the amount of time that we may expect capital gains will be diminishing. Along the way, some will make money by timing their holdings advantageously, as the price goes up and down from market demand, but the potential gains here will just keep going down with time just like an option does as we get closer to its expiration.

Bonds are, to a large degree, like a derivative, involving paper that is traded based upon the value of its income flow, the interest paid, if there is any of course. With a little time to go, there still may be people hoping that what they have the option on will come around, but with bonds simply paying back the principal at the appointed time, there really isn’t anything to vary but the market itself, and it does require some external stimulus.

Early on with these negative-yielding bonds, the time left plays a role, and there will be a point in time where we know for certain that their prices will drop below face value and start producing positive returns because we’ve reached the point where the cost of the negative yield is no longer justified by the bond’s speculative potential.

That’s a rather ugly outcome, but the nature of bonds is that some win and some lose and these will eventually become a hot potato that will find their equilibrium on the other side of negative, meaning capital losses mounting for the bondholders during the late stages.

Longer maturity dates add time to the clock though, and if you have 100 years, that’s going to take this issue right out of the question, for now and for a long while. In 50 years, if you are still alive, you still have 50 years to play with and that’s still a very long time.

The People Usually Get What They Want

Some investors therefore like the idea of longer maturities, and if low interest rates persist, this may be the future of bonds, to see the longer issues pick up in popularity. The 30-year treasury is a pretty popular one already and a 50 or 100 could be plenty popular enough.

Since treasuries do pay interest, we might think that this would not allow us to compare them with what we could call the hot potato effect of the 31-year Bund, but the way we have bid up treasuries, the potato will at least be warm, and extending the term like this would serve to cool them off for quite a while longer.

JPMorgan polled their clients about their interest in longer treasury bonds in 2017 and found that 27% of them were interested. They asked them again this year and discovered that nearly half of them now like the idea.

While dealers like this do have their own agenda, the voices of their clients do compete with it, and we might end up seeing at least a little change in attitude from dealers this time around.

Dealers are concerned about the viability of a 50 or 100 year long-term from the perspective of issuance, and this is a valid point at least. These sorts of bonds do better in the low interest rate climate that we are in now, but if rates go up, the demand for new issues may indeed dry up too much.

However, whether the Treasury issues a certain bond or not should not depend on the fact that they may still be issuing them 50 years from now, and it is quite reasonable for them to approach this from a need basis, issuing them when the climate is right and setting them aside when it is not.

Provided that we do have the demand for these, and it’s pretty clear that we do, there is no good reason why these very long bonds should not be issued, from both the perspective of the Treasury and investors. That is two pieces of the three and two influential pieces as well, as the combination of the willingness of both to do business like this will weigh on the dealers enough as long as the demand is indeed sufficient to make this all work.

All bonds suffer from time decay, which is not a desirable characteristic of them, and longer terms dilute this. As we see these long bonds issued by other countries gain more popularity, it seems just a matter of time before we see them on the American scene as well.

Ken Stephens

Chief Editor, MarketReview.com