By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Wolf Street.
“If I had an easy way and a non-risk way of shorting a whole lot of 20- or 30-year bonds, I’d do it,” said our favorite uncle Warren Buffett on CNBC. These kinds of bonds have been on a terrific bull run ever since Paul Volker, as Chairman of the Fed, cracked down on inflation. But now, even the avuncular face of capitalism would bet against them.
He was behind the curve. On April 22, Bill Gross, at Janus Capital, tweeted that 10-year German government debt was “The short of a lifetime.” The “only question” was “Timing.” Other bond gurus have jumped into the fray. Selling bonds outright, or selling them short if you didn’t already own them, particularly European government bonds, has become the thing to do in certain circles. Now valuations are falling, and yields are soaring off their ludicrously low levels.
So within the last 30 days, the 10-year US Treasury yield jumped from 1.83% to 2.23% as I’m writing this; the German 10-year Bund yield, instead of dropping below zero, skyrocketed from 0.05% to 0.60%; the Italian 10-year yield soared from 1.18% to 1.93%. And so on. Sharply rising long-term yields are percolating through the system.
In the era when several trillion dollars of even crappy government debt is so overpriced that it sports negative yields, thanks to central-bank machinations, this bout of selling is somewhat inconvenient.
Bonds with long maturities are particularly vulnerable. That’s what Buffett, the ultimate “smart money,” would focus on. And selling them is exactly what companies are doing at a record pace while there are still eager buyers for them out there.
When Oracle sold a bunch of bonds, it included $1.25 billion in bonds due in 2055. That’s 40 years from now. In return, Oracle will pay a coupon of 4.375%. Investors are dying for this kind of yield. Microsoft sold $2.25 billion of 40-year bonds back in February with a coupon of 4%. For both of them, it was a first. Massachusetts Mutual Life Insurance issued 50-year bonds.
So far this year, according to Bloomberg, companies have sold $39 billion in bonds that mature in over 30 years. That’s over five times more than during the same period in 2014.
Companies have pushed out duration – though it costs them more to do, for now. But they’re locking in the cheap money for a generation. Maturities for bonds issued so far this year average 16.4 years. If it stays the same for the full year, it will be a record, and far above the average going back two decades of 10.7 years.
Companies have sold $627.2 billion in bonds so far this year, up 6.57% from last year at this time, which had already been a record year. For the full year 2014, total issuance hit a vertigo-inducing $1.57 trillion.
So, companies are borrowing a record amount to fund share buybacks, acquisitions, and other mouthwatering hocus-pocus goodies. They’re leveraging up their balance sheets with these records amounts of debt, and they’re venturing at a record pace into maturities that exceed the remaining lifespan of many bond-fund investors.
These companies, too, are the ultimate smart money. They’re doing what Buffett would like to do, and what the shorts are now doing, this being the deal of a “lifetime”: they’re selling bonds that mature so far in the future that redeeming them is going to be another generation’s problem.
Heck, governments do it too. Even Mexico, which has a solid history of foreign-currency debt crises, a month ago was able to sell €1.5 billion in 100-year bonds at a 4.2% yield to maturity.
But for the buyers, for the very folks who have been scrambling over each other to grab a piece of this reeking pie, for the yield-desperate bond-fund managers, insurance companies, and others that have been driven to near-insanity by years of interest-rate repression and QE, for all those eager buyers who’ll end up owning these bonds in their conservative-sounding bond funds, for them, these bonds might curdle.
Never before has “duration” – the sensitivity of bond prices to interest rate increases – been higher, according to Bank of America Merrill Lynch index data cited by Bloomberg. If interest rates rise from these artificially low levels, these investors are going to take a bath. Bond funds are going to get hit brutally.
And if there is a big bout of inflation at any one time during the next many years or decades – a lot of stuff happens in 30 or 40 years – that record amount of debt, issued during times of super-low interest rates, will become the scourge of those who own it.
“The environment is much riskier for investors,” Jim Kochan, chief fixed-income strategist at Wells Fargo Funds Management LLC, told Bloomberg. “At these low-yield levels, it doesn’t take a big move to lock in losses.”
Those who bought the Oracle and Microsoft 40-year bonds have already taken a hit when yields began to rise. Even small increases in yields have a big impact on 40-year bonds.
But for companies it may be the last chance to get their hands on ultra-cheap long-term money as the Fed’s cacophony is increasingly clear that rates will eventually rise, even if much of Wall Street is clamoring for ZIRP Infinity. For 40-year bonds, it doesn’t matter whether rates begin to rise in June or September; 40 years is a long, long time.
And bondholders carry all the known and unknown risks of those four decades in return for what is still a minuscule amount of yield. That’s why the ultimate smart money is selling them at a record pace to still eager bond-fund managers that will stuff them, and all the associated risks and potential losses, without compunction into retirement nest eggs. Thank you hallelujah central banks for this deal of a “lifetime.”
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Well articulated! The “the efficiency of the market”. More like – the efficiency of a fee driven financial “services” industry. To callously pilfer the final morsels of dignity and hope – won so hard by so many good people. Who on earth would buy bonds now? And oh btw – how are going to fund our deficits?
Huh? Why does a government that issues its own currency need to ‘fund’ a deficit? You have the accounting backwards.
Oh boy! The same old arguments from the Taper Tantrum. Bond holders were going to take a bath then too. How did that turnout?
Sure the bonds have rallied hard since then and are now reversing, but as soon as this is priced into mortgages and new corporate debt issuance it will run out of steam. Higher yields are tantamount to a rate hike where it matters the most, and with global debt levels where they are there is no way it can last long.
As I wrote here two years ago, there is huge negative gamma for markets every time yields rise, especially up around 2.5% to 3% on the 10s, so they are all bailing out of longs now, and will be rushing straight back in when the blow out in borrowing costs smacks growth.
But traders will be traders, so have fun while it lasts.
It depends. I am not a believer in “economic growth” has to be fast or else gang. The US is a heavily built and modernized economy for example. The need for economic growth is dwindling and the US is doing more with less like ole Europe. IMO, we are seeing it in the declining velocity of money and thus slower inflation. Matter of fact, if core inflation goes over 2%, that is probably the sign of very low unemployment, probably even lower than the last expansion. Higher yields are just the sign full employment is around the corner in financial spheres. I am not talking about a blimp either like now, I am talking about a real move.
Globally, imo the current move is just Greek optimism as most yields were obviously shoved down on “worries”.
I would like to draw your attention to “duration” risk that results from 40 or 50 or 100 year bonds popping up during an anomalous period of ZIRP yield on US Treasuries other paper and mortgages from a decade ago. During the housing bubble, California had developed the “40” mortgage due to the astronomical run up on home prices. The only way to get enough mortgages to people was to create a new category of mortgage products stretching the payment out over another decade just to increase affordability. You could see these mortgages on sheets from Countrywide or Wells Fargo etc but the fine print would tell you they were for CA deals only. Imagine sub-prime and 40 years amortization as a cocktail for even bigger derivative madness leading up to 2008!! The current bond market, could it have parallels to the mortgage market signals of a near term debacle with their own unusually long “durations”?
Your point is well taken that 40-year mortgages suggest excess. But because most mortgages are paid off or refinanced long before they mature, a 40-year term doesn’t affect their duration very much.
MBB, the largest mortgage backed securities ETF, has a weighted average maturity (taking account of prepayments) of 5.32 years, and an effective duration of only 3.43 years (less than a Treasury note with 4 years to maturity).
Wolf is howling again about bonds. He will be right eventually. He’s got forever on his side. But forever is a long time. No growth from stagnant economies will result in low interest rates for a long, long time. It ain’t gonna change probably in his lifetime.
I think that the most salient fact about rates on long-term government bonds is that most governments simply can not afford to pay the true rate of interest that the markets would demand if the markets were still free.
The central banks are desperate to keep rates low in virtually every country because governments with public debt ratios of 100%, 150% or even 180% simply can not afford to pay reasonable – say, 5% – average rates on their debt. That would mean that interest payments would be equal to 5%, 7.5%, and 9% of GDP for such nations, respectively.
No politician will ever allow a central bank to force him to raise taxes by 5% or more of GDP.
Japan is the leading edge of central banking today, as the Bank of Japan has essentially lost its independence and is monetizing one quadrillion yen in debt. If rates were allowed to float freely, every yen collected in tax would still not suffice to pay the interest. Hence, rates can never again be set by a free market until after the current scheme collapses.
Ironically, Russia is the only major country that can sustain high interest rates, as they had already monetized their debt just after the Soviet Union collapsed and now have room to maneuver.