Austria's 100 year bond.

If you create a bond with a 2% coupon in a world where interest rates are 0.9%, you can bet that that bond is going to be very very volatile. 

Case in point - Austria's 100 year bond that matures in 2117.  (note: register for the economist and you can view a few articles for free).

My quick calculations show that this bond has a duration of about 56.  That's pretty high!  I'd be interested to know whether investors are buying this a straight bet on interest rates or whether they are using it as part of a portfolio.  You wouldn't need much of this bond to tilt the duration of your portfolio higher.

Here are my excel computations, with the predicted price change using duration alone (which is not terribly accurate in this case).  For bonus points - explain why this is the case...

A 30 second course on asset allocation

From Josh Brown:  http://thereformedbroker.com/2014/11/06/thirty-second-course-on-asset-allocation-2/

Josh cites Jeremy Siegel's classic "stocks for the long run" which argues, that over any 30 year period, stocks virtually always beat bonds.   Still this doesn't mean that everyone should be 100% stocks - a topic that I've blogged on quite a bit over the years.   You can see my old posts here:

http://financeclippings.blogspot.com/search?q=stocks+for+the+long+run

Why would a non-profit issue taxable bonds?

To avoid regulation.   Apparently, universities are increasingly issuing taxable bonds (where the bond buyer has to pay taxes on the interest) in order to get greater flexibility in where those funds can be used.   In effect, the borrowers are paying more interest to avoid covenants imposed the federal government.

Junk Bonds to fund Noah's Ark?

Unbelievable, but true.

The bonds will have no secondary market, are callable at any point, have no guarantee by the issuer and pay about 5% interest.  Oh, and they are going to pay for a museum called "Ark Encounter".  

What could go wrong?

An interesting take on floating rate notes

There's been some discussion of whether the Treasury should issue floating rate notes.   Some people argue that doing so would expose the government to interest rate risk, but as this blog posting points out, this risk is already present in the current way that the government issues short term debt.  

An interesting piece and worth the read.

Treasury considering floating rates notes.

Very interesting.  Yet another thing to cover in the bond lecture!  Of course higher interest rates mean that the Government's liability would increase (As Campbell Harvey of Duke notes in the article), but this is already the case with TIPS, so I would wonder to what degree investors would actually just substitute these new bonds for TIPS.

(reposted from financeprofessor)

Negative convexity in mortgage bonds

I love it when the real world behaves in just the way that I wrote on the class room white board!

Case in point: Mortgage bonds have negative convexity over certain ranges of interest rates.  This means that when rates fall the value of the bond falls instead of increases as would be the case for a typical bond.  The reason for this effect is refinancing by the homeowners whose mortgages make up the cash flows of the bond.  As these homeowners refinance, the amount of promised cash flows declines, and so does the value of the bond.   Interest rates matter here because lower interest rates result in more refinancing.

OK, so what is happening today?  Well, there are a lot of homeowners who can't refinance because they have negative equity.  So even though they see interest rates fall, they cannot take advantage of these lower rates, that is, until now.  President Obama's latest initiative to enable these under water homeowners to refinance will result in many mortgage bonds getting paid off early and, as a result, fall in value.

The FT has a great article on this which notes that only the mortgage bonds which had coupon rates that are above the prevailing mortgage interest rates suffered a price decline around the announcement of the plan - exactly as we would expect.

As noted in the article, part of this plan is basically paid for by a wealth transfer from the mortgage bond holders to households.

Price risk in the junk bond market

In one of my classes we've been talking about price risk and reinvestment risk for bonds.  These occur when market rates move from the initial YTM that an investor purchased the bond off of.  A great example is the current junk bond market where yields have risen very high and resulted in prices falling dramatically.  As a result year to date returns on these bonds are now negative.

Article here, HT Felix Salmon

Google's bond issue...

Perhaps Google issued bonds because of a tax angle (a large amount of Google's cash is parked overseas and will incur taxes if it is repatriated.)  As a colleague of mine said (on more than one occasion) - "I bet there is a tax story here somewhere."

Via Greg Mankiw

Google plays the yield curve

Greg Mankiw talks about Google's recent sale of $3billion of bonds.  The sale is a little surprising given that Google is sitting on $37 billion of cash.  One potential explanation is that Google is looking to stock pile more cash in case it wants to go on a spending spree.  An alternative explanation is that Google is seeking to establish a debt rating for future debt issues.  

The details of the deal are documented in the Wall Street Journal article.  Clearly Google has extremely low borrowing costs.

The (Google's) 10-year bond, for instance, will yield 3.734%, compared to 10-year Treasurys, which yield 3.15%.

Hedge funds searching for ways to short munis

Munis - the name given to municipal bonds - are bonds sold by states and state agencies.   For years munis have been considered safe and boring.  But now, with many states facing severe budget crisis, investors (and in particular hedge funds) are paying close attention to munis.

If you are running a hedge fund, you might sense an opportunity here.  If you believe that the credit worthiness of states will continue to decline, then the price of munis should fall (and at the same time the yield on these bonds will increase).  The obvious strategy then is to go short munis.  The question then is how?

The Financial Times tackles this question.  First it turns out that shorting muni bonds is quite hard as most muni debt is held by buy and hold investors like pension funds who are not interested in lending the bonds out to short sellers.  Second, even though in theory you could buy credit default swaps, the market for muni CDS contracts is pretty thin and as a result there are liquidity issues.  Finally, you could just try and short a muni index, but you won't be able to target a specific state.

For students of finance, this is what we call a "limits to arbitrage" problem.  While in theory the smart money should try and short overpriced bonds, frictions in the market render such a strategy costly or unpractical.   It is important to note however, that this doesn't mean that markets are not efficient, just that they are not perfect.  There is a difference.

Should the US issue 100 year bonds?

There's been some talk in the press about whether the US Treasury should issue 100 year bonds.  The idea is that by issuing long term bonds, the government would be able to lock in the current low interest rates.   The fundamental premise seems a little silly really.  First of all, the idea of locking in long term rates assumes that rates will, on average be higher than they are currently.   If this is so, then why would anyone buy these bonds off a low rate.   Put another way, to make this argument you have to assume that the Treasury has better rate forecasting ability than the market.

Another argument for these bonds is that there is demand for them from various institutional investors.  So why would investors demand long term bonds?   The most obvious reason is that long term bonds tend to have high duration.  This means that their prices are more sensitive to interest rate movements than shorter duration bonds.  Counter-intuitively, these long duration bonds are actually very useful for managing interest rate risk - particularly when used in immunization strategies.

So this all sounds good, but it turns out the the Federal Government already issues a longer duration bond than a 100 year bond.  The duration of a 100 year 4% coupon bond selling off a yield of 4% is actually about 25 years.   However, 30 year STRIPS, which are zero coupon bonds, have a duration of 30 years.  Therefore the duration argument doesn't really seem to make much sense.  The only small advantage to 100 year bonds is that they have higher convexity than the STRIPS.

You can check these numbers using the Bond function on wolfram alpha.

Bottom line, I don't think that 100 year bonds have much of an advantage over currently available bonds.

Is high inflation around the corner?

Probably not. We talked about the spread between TIPS and Long Government bonds in class this week and in particular how this spread is only about 250 basis points. This spread represents the market's expectation of inflation embedded in bond prices.

Greg Mankiw makes the same point in his article tomorrow (Sunday) in the New York Times. You can read it here.

FF on duration, term structure and immunization

Great post on the Fama French blog about long term bonds.

I have a new fave blog

Check out http://self-evident.org/. Particularly the Bond Crash/Course section. Great stuff on the mechanics of swaps and loads of other goodies.

Finding this stuff interesting is a sign that you are a true finance geek! For example, the most recent post explains how you can extract inflation expectations from swaps. Brilliant stuff!