Rising bond yields pose an outsize threat to one asset class in particular: ultra-long-dated debt.
Hopes of a fast economic recovery have given bonds their worst start to the year since 2015. Last October, 10-year Treasury yields were under 0.7%. Now, they hover around 1.5%. The jump has started to dent stocks: The S&P 500 fell 2.4% Thursday.
Markets still benefit from very loose financial conditions in inflation-adjusted terms, and the Federal Reserve made clear this week it won’t allow yields to go too high. That offers protection to stock investors, and even most bondholders.
The exceptions may be investors that bought debt issues maturing in 50 or more years’ time, particularly those with slim coupons.
So far, the big yield shifts are happening at shorter maturities. Yet France’s new 50-year government bond, issued on Jan. 26, has still lost 15% of its value. Over the same period, Austria’s latest 100-year bond has lost 21%. Their yields have only risen 0.4 percentage points.
The explanation lies in complicated bond math.
In traditional calculations, prices move in the opposite direction to yields in roughly a straight line, and this line is steeper—the bond has more “duration”—the longer the maturity. If an investor buys a one-year bill when yields are at 1% and they rise to 3% there isn’t that much damage done, because the money will be repaid in 12 months. The same yield increase with a 10-year Treasury would give investors low returns for the next decade. The market value of the bond has to fall by more to compensate.
This straight line is just an approximation, though, because prices are more sensitive to yields at lower yields than at higher ones. The relationship is really a curve, particularly for long-dated bonds.
This used to be a pedantic detail for academics, but that changed in the past decade as interest rates plunged to all-time lows. Bonds maturing in 30 years or more became highly attractive. Investors found they had more upside and less downside than the straight line suggested.
Pension funds and insurers, which need to hedge long-term liabilities, became particularly hungry for them. Many governments have been happy to oblige, and started issuing longer-dated debt. The U.S. is now considering a 50-year bond.
But investors could be underestimating the dangers, according to research by finance professor and Commerzbank analyst Jessica James. Because rates are now often zero or negative, many ultralong bonds issued in recent years came with tiny coupons. The size of a bond’s payouts are often inconsequential for investors compared with the overall yield, but low coupons mess with the math of very long-dated bonds. Pension funds and insurers face more downside and less upside than they may have thought.
With 100-year paper, for example, the potential losses from yields rising even modestly, say from 0% to 2%, are staggering. Investors who bought paper with a 3% coupon when yields were zero lose 64% of their money. Those that bought it with a 0% coupon lose a whopping 86%, according to Ms. James’ calculations.
Investors who aim to hold long-dated paper to maturity have less to worry about. But given that people—and even currencies—don’t always survive 100 years, it may be time to start crunching the numbers again.
Write to Jon Sindreu at [email protected]
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