Investing for the long, long, long term
MARTIN MITTELSTAEDT
From Tuesday's Globe and Mail
Published Monday, Nov. 08, 2010 5:16PM EST
Last updated Wednesday, Nov. 24, 2010 11:37AM EST
Goldman Sachs (GS-N167.60----%) just issued a 50-year bond. The Government of Mexico, U.S. railway giant Norfolk Southern Corp. (NSC-N62.44----%), and Dutch banking conglomerate Rabobank Group did one better: They all recently issued bonds with the stupendous term of 100 years.
The clamour from investors for these ultralong bonds is raising eyebrows in the capital market. The Goldman issue is slated to return investors their money way off in 2060, while 100-year bonds won’t pay back their principal until a century from now.
Bonds are basically just a way to lend money, but until recently it was unusual for any investor to be so trusting as to lend money for up to a century. During such an extended period, bond issuers can run into revolutions, depressions, bankruptcies and all manner of other reasons for non-repayment. Up until now, normal terms for long bonds were considered to be 10 and 20 years.
Despite the risks, yield-hungry investors are snapping up these superlong-term securities. While 10-year government bonds are yielding around 2.75 per cent, Goldman and the other issuers of long, long bonds are offering the tempting inducement of rates around 6 per cent.
The high yields explain the popularity of the offerings, but the bonds’ terms are so extreme that many market pros believe they are a signal that the long-running bull market in fixed-income securities has reached the limits of rationality. Investors fixated on finding a good yield are ignoring the dangers that go along with investing in bonds that won’t mature for a couple of generations or more.
Going 'Very, Very Wrong'
“Some of these deals are going to go very, very wrong,” frets Ric Palombi, a fixed-income portfolio manager at McLean & Partners Wealth Management, who oversees approximately $1-billion in assets.
Mr. Palombi isn’t buying the bonds for his clients, and is surprised they’ve become a hit. “I never thought they would be so prevalent.”
The Goldman issue is a poster child for the continuing frenzy in the capital market for long-dated instruments. The Wall Street bank originally hoped investors might have the appetite for $250-million (U.S.) worth of the securities, according to market chatter at the time of the issue last month.
But Goldman sold more than five times as much – $1.3-billion. Ordinary ma and pa investors were the target buyers, signified by Goldman chopping the bonds into minuscule $25 amounts. This is an unusual size. Bonds typically trade in minimum multiples of $1,000.
How They Work
It’s not clear how many of the small investors who bought Goldman’s bonds realize the fine points of the deal. According to the prospectus, Goldman has reserved for itself the right to redeem the bonds at their face value of $25 on five days’ written notice any time after Nov. 1, 2015.
If interest rates stay low, Goldman, which didn’t respond to a request for comment, will likely call the bonds and pay off investors. Those seemingly high yields will then vanish.
Meanwhile, if market interest rates return to more normal levels because the economy recovers or inflation resumes, it’s likely that the cost of borrowing for extremely long terms could rise well above the 6.125 per cent that Goldman is paying. In that case, Goldman won’t redeem them, and buyers will be stuck with losses because bond prices move inversely to interest rates.
It’s telling that, while Goldman has the right to redeem, buyers weren’t given the same right to force Goldman to buy back the securities if interest rates surge.
While investors in any long-term bond face the risk of the issuer defaulting, any strong uptrend in interest rates also poses a problem.
Bond prices are in the midst of the longest bull market on record, having rallied in the United States for the better part of 29 years. Back in 1981, when the bull run began, 10-year U.S. Treasuries were yielding about 15 per cent and were shunned as “certificates of confiscation” by investors. Now the yield is a tad under 3 per cent and investors are snapping up bonds.
What Goes Up...
Nothing goes up forever, some analysts caution.
“Within a couple of years, the bond market probably is going to be entering some kind of [long-term] bear market,” says Frank Hracs, who compiles the Canadian Mutual Fund Analyst, a publication that tracks fund inflows and has found the hottest area is currently in bonds.
Mr. Hracs worries that the “long-term outlook for bond capital gains is negative.”
The losses owing to any rise in rates could be devastating. If rates revisit their 1981 levels, the 50-year and 100-year bonds will collapse in value by about 60 per cent.
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