A five-decade bond implies that inflation no longer is a concern. Rather, it's liquidity that matters most in long bonds now

By Andrew Allentuck | July 2014

It's a clear sign of the times: 50-year bonds are back. With inflation on hold and investors worried that the current recovery is long in the tooth, the bond rally, which was expected to fizzle out with the ending of the U.S. Federal Reserve Board's quantitative-easing program, has returned to life. Bond bears seemingly have thrown in the towel while the bond bulls are smirking all the way to the bank.

On May 5, Caterpillar Inc. issued US$500-million worth of 50-year bonds maturing in 2064 with a 4.75% coupon, which is 120 basis points (bps) more than is offered by the 30-year U.S. treasury bond recently priced to yield at 3.35% to maturity.

A five-decade bond implies that inflation no longer is a concern. Instead, there's a new rule book for long bonds: it's no longer returns that matter; it's liquidity.

This trend is happening north of the border, too. In mid-May, the Government of Canada issued a 50-year bond due in 2064 with a 2.75% coupon, which, at the time of writing, was priced to yield 2.73% to maturity. In comparison, a 10-year Canada bond recently yielded 2.28% to maturity. A 45-bps spread for 40 years over the 10-year Canada usually would not tempt buyers, but this time it's different.

Institutional investors, such as big insurance companies and reinsurers, are buying the long issues in order to have massive liquidity available on demand. This is a market in which returns don't matter as much as maintaining reserves and capital. But well-structured institutional portfolios will be more saleable and make regulatory compliance easier, which is critical.

U.S. pension fund regulation has put more weight on long bonds in pension fund portfolios, encouraging them to buy more long-dated government debt to match long-term liabilities. Canadian regulators are taking a similar course, notes James Hymas, president of Toronto-based Hymas Investment Management Inc. All of this has pushed up the prices of mid- to long-term bonds.

"Rising bond prices do not offer a fundamental view of where rates are going," says Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. "It is a statement of basic demand for hedging liability to pension funds. For them, long issues will not be traders."

With long-term interest rates dropping for the moment, investors are accepting a lot of interest rate risk. The 50-year Canada, for example, has a duration of 27.5 years. That means a one-percentage-point rise in interest rates will make the bond's price drop by almost 28%. An alternative is to buy high-yield debt, but eager buyers have pushed up junk prices to the point at which the Merrill Lynch master II high yield index offers a yield of 378 bps over 10-year U.S. Treasury bonds. (The all-time low in the spread over U.S. treasuries is 250 bps; the average is 600 bps.)

The risk in loading up on junk bonds is not just an increase in the default rate. Rather, it's having the carpet pulled out from under investors as exchange-traded funds start dumping their junk-bond index holdings when the U.S. economy, which is where most junk bonds are issued and traded, enters recession. The dumping of junk bonds will add volatility, further reducing the value of junk, Kresic says. That's all the more reason to buy into a "moat of safety" found in long investment-grade and long government bonds.

The current wisdom defends adding interest rate risk to bond portfolios. Doug Porter, chief economist with Bank of Montreal in Toronto, wrote in a May 23 brief that "average growth rates will be slower; get used to it." His argument is that average real annual gross domestic product (GDP) growth rates have been declining since the 1960s, with each decade's GDP growth being lower than its predecessor. That implies prospects are slight for a return to high inflation and the subsequent high interest rates that would eviscerate bond returns.

Evidence to support Porter's view exists: average real annual GDP growth in the 1960s was almost 6% in Canada, then declined to 4% in the 1970s, to 3% in the 1980s, to 2.5% in the 1990s and to 2% now, with the Bank of Canada estimating that GDP growth this decade will be 1.9%.

How long the bond rally will last depends on a balance of macroeconomic factors, such as inflation and the bond market - mainly institutional demand for bonds. Eventually, says Jack Ablin, executive vice president and chief investment officer with BMO Harris Private Bank in Chicago, macroeconomic forces have to win: "Recent interest rate declines have made long-dated, fixed-rate bonds vulnerable to growth and rising inflation expectations. We believe fair value for the 10-year U.S. treasury [bond] is 3.7%.

"It is liquidity factors that are keeping interest rates low," he adds. "But it will take a realization by bondholders that they are sacrificing in purchasing power. Right now, they are paying for liquidity and accepting mild inflation erosion. The distortions are in buyers who don't care about making a profit or who can make it other ways. As long as central banks are buyers of bonds, liquidity is guaranteed."

The reversion to historical interest rates, which parallel inflation, has to take place - someday. As Hymas explains: "The current situation of low bond yields, which barely cover inflation running at 1.5% per year, cannot last. Doing that with 50-year government debt is not prudent for anybody who does not need half a century's worth of liquidity."

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