This article was taken from the autumn issue of the 1875. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications
In October, yields on 30-year US treasuries reached a 16-year high on the back of a market-wide sell-off. Partly behind this sell-off was a tranche of data suggesting the US economy was much stronger than expected. The monthly release of non-farms data – the payroll data of around 80% of all workers in the US and an important measure of the health of the US economy – showed that 336,000 jobs had been added in September, far outstripping expectations. Given the apparent resilience in the economy, the Federal Reserve has been indicating that it intends to keep its benchmark rate (currently 5.5%) higher for longer. With this news digested, markets adjusted to accommodate a longer period of relatively high interest rates and correspondingly higher borrowing costs.
The impact was seen most strongly on the longer dated treasuries. Let’s explore why and take a look at how long-dated bonds behave and their relationship with interest rates. The parameters of what exactly classifies as a long-dated bond vary. In the US, this usually refers to a 30-year treasury – the longest maturity issued in that market. In the UK, anything maturing in 15 years, or more is called long dated. The UK has also in the past offered ‘ultra-long’ gilts with maturities of 50 years, primarily aimed at helping pension schemes in planning to meet their long-term obligations. Corporate bonds can be issued with a variety of maturities. New US issues in 2023 had an average of 10 years to maturity.
Given their time horizon, investors in long-dated bonds are more exposed to interest rate risk, default risk, and the effects of inflation on coupons and the capital value of the bond at redemption. As such, they are usually compensated with a higher yield – a risk premium. Likewise, shorter-dated bonds usually offer a lower yield as their investors are taking on less of a risk. The respective yields of bonds over the various maturities can be plotted on a graph. This is known as the yield curve. As we have discussed, generally a longer-dated bond has a higher yield than a shorter one, and so the yield curve typically slopes upwards. When this yield curve deviates from its usual shape, market participants often use this as an insight into what market forces are at play. For example, when short-dated yields rise above long-dated, the curve is said to be inverted. A common explanation for this phenomenon is that markets are expecting interest rates to fall. A strongly inverted curve has historically been an indicator of an impending recession.
Given that yields and interest rates are so fundamentally linked, bond investors need an objective measure of interest rate risk which takes into account a bond’s maturity, yield and coupon. This measure is called duration. It is expressed as time in years, which reflects the time taken for the price of a bond to be returned via its cashflows. A bond which has a low coupon and/or is long dated will have a longer duration. The higher a bond’s duration, the greater its sensitivity to changes in interest rate and, therefore, its volatility. A cautious investor, or one who is expecting interest rates to rise over time, would find a bond with a shorter duration more appealing.
In the years following the Great Financial Crisis of 2008-09 interest rates were slashed in a bid to revive the economy. There they languished, until soaring inflation prompted central banks to begin raising them again. During this period of near-zero rates, bond issuers did not need to offer much in the way of coupons to make their issues attractive to investors. Additionally, some bonds with extremely long maturity dates were issued. One notable example was the hundred-year Austrian government bond which was launched in 2017 with a 2.1% coupon. By September 2019,
The Economist proclaimed the headline “Austria’s 100-year bond has delivered stunning returns.” And at the time it was true, having returned 75%. Investors would have been thrilled. By late 2020, as governments sought to shield the economy from the impact of COVID-19 measures by keeping rates suppressed, the bond had reached an all-time high, trading at over double its face value. That same year, another century issue was launched, with a coupon of only 0.85%. It was eagerly snapped up by investors, with €16bn in orders submitted.
It couldn’t last. With their low coupons and ultra long maturities, the Austrian century bonds were extremely sensitive to changes in interest rates. When rates began to rise again, the resulting effect on these bonds was inevitable and brutal. The 2017 issue currently trades at 64 cents on the Euro. If bought at its peak and sold today, this would represent a loss of around 75%. The 2020 issue has fared no better, and trades below 33 cents on the Euro. Consider also that Austria has one of the highest credit ratings and has never defaulted on either bond. The change in the direction of interest rates alone has been enough to inflict heavy capital losses on the unfortunate investor. These are perhaps somewhat extreme examples, but nevertheless serve to illustrate how long duration can be a dangerous thing. Beware the long bond – it can be all too easy to become entangled.
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.