The U.S. Treasury reopened the 30 year Treasury bond market Thursday, with the first 30 year bond issue since such issues were suspended in 2001. The issue of $14 billion 4.5 percent bonds due February 2036 was twice covered on a yield of 4.530 percent, with an indirect bid from domestic institutions and foreign central banks for 65 percent of the issue, much higher than had been expected and a highly successful result. Looking at those investors’ likely long term real return, one can have only one comment: suckers!
U.S Treasury bonds are not always a lousy investment. In August 1982, when Merrill Lynch arranged the first stripped zero coupon Treasury bonds, they sold the longest maturity, August 2012, at a yield of over 11 percent, at a time when regular Treasury bonds yielded close to 13 percent. If you bought that maturity, you put only $4 down in 1982 to receive no interest payments during the bond’s life, but a full $100 at its maturity in 2012 (through the magic of compounding, an 11 percent yield gives you a SERIOUS capital gain over 30 years.)
Inflation in the 12 months to July 1982 was 6.4 percent and was dropping sharply, as heroic Fed Chairman Paul Volcker had established his vice-like grip on the U.S. money supply. Thus you could lock in a real yield of almost 5 percent net with the U.S. government as security. What’s more, you had the chance to make an even higher return if you sold the bond after interest rates had dropped but before maturity. If you had sold $100 nominal value of that bond 11 years later, in 1993, by which time it had 19 years to run and would have yielded about 6 percent, you could have got $33 for it, a return of over 8 times your $4 investment in 11 years, or 21 percent per annum – handily better than investing even in the bull stock market of 1982-2000.
You would have done nowhere near as well buying medium term bonds in 1982, even though such bonds had a nominally higher yield. Much of the return on a long term bond investment comes from the reinvestment of the yield on the bonds over their life. By buying a zero coupon bond or a bond with a very long maturity and a high yield, you have locked in a high return for a lengthy period and will benefit if interest rates decline.
That is much less true for long term bond investments in periods of low interest rates, which are all risk and no reward. To take an extreme case, the British government recently issued 50 year index linked “gilt” bonds with an interest rate of 0.46 percent plus inflation. Even though British pension fund investors have pension liabilities linked to inflation that they need to match, such bonds make very little sense as an investment.
It is most unlikely that investors will have a reinvestment problem caused by index-linked interest long term rates falling below zero — although unlike with nominal rates, there is no structural reason that they shouldn’t, because there is no “index linked cash” that can be held as an alternative. Conversely, there is every chance that investors will in real terms suffer a capital loss caused by one of two factors, both of which are highly likely. First, real yields on British long term bonds could return to their historical average in the 2-3 percent range, causing a large capital loss for investors who needed to sell these very long maturity bonds with almost no running cash flow. Second, the British government could follow its transatlantic cousins and fiddle the price index – by including phantom “hedonic” quality gains or otherwise – and thus by lowering the apparent rate of inflation artificially reduce the yield on these 50 year bonds below that nominally quoted.
Since British pension payments and other social security payments are linked like the bonds to the Retail Price Index and Britain, like other countries with a low birthrate and longer life expectancies, has a long term demographic problem in its social security system, at some point in the next 50 years the temptation to fiddle the Retail Price Index will probably prove overwhelming.
The reinvestment risk in the new 30 year Treasury bond is similarly one-sided. While bulls can point to the 3-4 percent interest rates on long term Treasury bonds before 1960, pessimists can point out that those yields were achieved in a period before the Fed had fully demonstrated to the bond markets the political attractiveness of sloppy inflation-producing money supply control. Over the last 30 years, 1975-2005, the Consumer Price Index for all urban consumers has risen by 4.31 percent per annum, even without adding back the “hedonic” price index manipulation of the last decade – thus based on that period, the real yield on the new 30 year Treasury bond is likely to be less than ¼ percent per annum.
Even over the entire 92 year history of the Federal Reserve system, 1913-2005, inflation has averaged 3.29 percent per annum, and for the first half of that period the United States was nominally on the Gold Standard. The Gold Standard may be thought by conventional opinion to be unacceptably deflationary, and inferior to a politically dominated Fed, but in practice a political Fed will only achieve its woolly definition of “price stability” – inflation less than 2 percent per annum – in times of low economic stress; over the long term the inevitable disruptions will cause the average level of inflation to be substantially higher than this. Buyers of 30 year bonds should be aware of this; judging by Thursday’s enthusiasm they are ignoring it.
There is however a further risk in investing in U.S. government bonds beyond that of inflationary erosion of principal and that is outright default, or an Argentine-style government-instigated inflation that technically avoids default but destroys investors’ capital anyway. This appears unthinkable for the United States, indeed U.S. government bonds are the epitome of the “risk free” security, yet in reality every cost-free default in Third World countries such as Argentina or Russia makes a U.S. default more likely, because it reduces the risk aversion of government policymakers.
Japan for example was thought in 1990 to be among the strongest credits in the world, yet 15 years of deflation and recession left it struggling with gross government financial liabilities of 160 percent of Gross Domestic Product (on OECD statistics, chosen for international comparability.) Given Japan’s very low interest rates and its increasingly vigorous economic recovery, default in Japan seems unlikely, yet had prime minister Junichiro Koizumi not come to office in 2001, and the wrong policies been followed, the situation could very easily have spiraled out of control. Italy too, with government debt of 126 percent of GDP, a difficult demographic outlook and intermittent political instability must have a significant probability of default on a 30 year view.
The United States appears at first sight not to have such a problem, since its debt to GDP ratio is a mere 64 percent of GDP, below its level in the 1990s though up from 58 percent in 2000. However, it should be noted that Japan’s debt to GDP ratio was only 65 percent in 1991, at the beginning of its long recession. The inability to control federal spending that followed Speaker Newt Gingrich’s removal in 1998 and President George W. Bush’s election in 2001 has led to a Federal budget deficit that is expected to total $423 billion, 3.2 percent of GDP, in the year to September 2006, four full years into an economic recovery and at a time of full or even over-full employment.
The current Federal budget situation is even worse than it appears. In the year to September 2005, Federal budget receipts increased by 14.5 percent, far in excess of the 7 percent increase in nominal GDP and $108 billion above the estimated revenues for the year given in the President’s budget message given in February 2005. However, projected expenditures in the year to September 2006 have increased by even more compared to the President’s February 2005 request, by $141 billion above the President’s request, and by 9.5 percent above the previous year’s expenditure level – a truly disgraceful performance in a year of rapid economic recovery.
Every fiscal year since that to September 2000, in which House Speaker Dennis Hastert replaced Gingrich, final expenditures for the fiscal year have exceeded the amount originally requested by the President by at least $25 billion, and the gap is growing uncontrollably larger. The projected $423 billion deficit this year is the second largest on record, has been incurred after five years of exceptionally low interest rates (which reduce the government’s short and medium term interest costs) and can be expected to grow rapidly as soon as the next recession hits. We are about to find out how large a deficit the federal government can finance; my own estimate is that a series of deficits in the $750-900 billion range would quickly cause huge strains on the bond markets, damage the U.S. economy as a whole, and cause the U.S. debt to GDP ratio to spiral out of control as did Japan’s in the 1990s.
The long term picture is even grimmer. While the Social Security trust fund is not expected to go bankrupt until 2041, safely after the 2036 maturity of the bonds the silly investor has just bought, the Medicare Hospital Insurance trust fund is expected to go bankrupt in 2020, less than half way through the bonds’ life. Those bankruptcies will not themselves cause a default on the bonds, of course, they will just require painful and politically very unpopular tax increases or benefit cuts in order to continue the programs’ viability. Care to speculate on how easy those choices will be, and how attractive it will appear to debauch the dollar and/or stiff bondholders, to make the problem go away?
As a U.S. taxpayer, I am delighted that the Treasury has reintroduced the 30 year bond – it gives every promise of allowing the inevitable budget deficits to be financed for a maturity probably exceeding my remaining lifetime at a cost close to or even less than zero in real terms.
I just don’t propose to invest in them!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.