A worrying sign in bonds

Statue outside Austrian parliament © iStock
A 100-year IOU: will she be good for it?

Austria this month became the first eurozone nation to sell a “century” bond – an IOU that matures 100 years from its issue date – in public markets. Both Ireland and Belgium have sold 100-year bonds, but only as private placements (ie, sold direct to a handful of interested buyers) and in amounts of just €50m-€100m. Austria, on the other hand, raised €3.5bn from the sale, priced at a yield (interest rate) of 2.1%. So it’s a first for a currency that’s been in use for less than 20 years, and for a country that has only been independent for 62 years.

Yet investors were queueing round the block to buy – bids from potential investors reached over €11bn, according to the Financial Times. And it’s not just Austria – the appetite for “ultra-long” dated bonds (those with maturities of more than 30 years) is high right now. Globally, $63.5bn of such debt was issued in 2016, and so far, reports the FT, another $43.6bn has been sold this year. Indeed, in June we wrote about the highest-profile of these bonds – an Argentinian 100-year debt issue. That seemed the most “irrationally exuberant” bond issue you could imagine, given that it came from a country with a strikingly poor credit record. However, while it was certainly expensive, keen buyers noted that – with its 8% yield – the Argentinian bond would repay its face value after just eight years. So you could make a case for buying it (making a lot of optimistic assumptions we personally wouldn’t).

The Austrian bond is very different. Its low yield means it would take 44 years for buyers to recoup their initial capital. In the jargon, the bond has a very high “duration” (see below) – the highest for any eurozone bond on the market. In short, a high duration means its price is very sensitive to changes in interest rates. If rates go up, the price will fall; if rates go down, the price will rise. So it’s interesting that demand is so high – it implies that investors expect global rates (and eurozone ones in particular) to remain low despite central-bank promises of “tapering”, which makes the 100-year bond look attractive next to the lower-yielding 30-year one. Yet given that the European Central Bank is under pressure to taper (reduce quantitative easing), that might be a risky bet.

So it’s revealing, say Marcus Ashworth and Mark Gilbert on Bloomberg Gadfly, that just 7% of this bond went to traditional holders – pension funds and insurers who need to match liabilities with long-term assets. The rest (65%) went to fund managers. “That is a worrying sign, suggesting the bond may not prove to be quite so locked away in a vault as the ultra-longs normally are.” There’s a good chance this bond could be a lot cheaper this time next year.

Duration explained

Duration is a measure of risk related to bonds. It describes how sensitive a given bond is to movements in interest rates. Think of the relationship between bond prices and interest rates as being like a seesaw: when one side (interest rates, for example) goes up, the other (in this case, bond prices), goes down. Duration tells you the likely percentage change in a bond’s price in response to a one percentage point (or 100 basis points, in the jargon) change in interest rates. The higher the duration, the higher the “interest-rate risk” of the bond – ie, the larger the change in price for any given change in interest rates.

Duration also tells you how long (in years) it will take for you to get back the price you paid for the bond in the form of income from its coupons (interest payments) and the return of the original capital. So if a bond has a duration of ten years, that means you will have to hold on to it for ten years to recoup the original purchase price. It also indicates that a single percentage point rise in interest rates would cause the bond price to fall by 10%. As a rough guide, duration increases along with maturity – so the longer a bond has to go until it repays its face value, the longer its duration. Also, the lower the yield on the bond, the higher its duration – the longer it takes for you to get paid back.

All else being equal, a high-duration bond is riskier (more volatile) than a low-duration bond. For zero-coupon bonds (bonds that don’t pay any income at all), the duration is always the remaining time to the bond’s maturity. For interest-paying bonds, duration is always less than its maturity (because you will have made back your original investment at some point before the maturity date).