Time to Lock in Those 100 Year Rates

It's taken several months and a drop of several hundred basis points, but the inflation hysteria from those myopic economists focused only on the monetary base has finally given way, as even Morgan Stanley's chief bond bear, Jim Caron, capitulated over the weekend and is now on the 10s-30s flattener bandwagon. It's worth reviewing what he said about the 30 Year on (or about) June 29, 2010:

A Counter Point to the Deflationistas

If true deflation fears were at work in the market then one should expect the longest duration points on the curve to rally most and we would see a significant flattening of the yield curve, especially the UST 10s30s segment of the curve. We use this as a check against deflation fears. Instead, we see the opposite with the UST 10s30s curve right up against its 20-year highs. If deflation is truly at work in the market, then someone ought to tell the UST 10s30s curve. And for that matter, all curve segments should be much flatter. Yet the curve flattening has been slow and grudging. Thus the yield curve is more representing an overall shift to lower yields as the Fed is expected to be on hold for a long time, not that deflation is truly at work. Don't confuse the two. It's too early to conclude that deflation is truly at work in the marketplace.

At the time, we had a different opinion (and it's also worth noting that the spread between the 10 Year T-Note and 30 Year T-Bond was still within its 2009 trading range):

[Caron's] observations on the 10s30s spread are leading to an erroneous conclusion. That segment will be the last to contract because (a) there is a real and rising risk of US default as evidenced by credit default swaps (30 years is 3 times as long as 10 years, after all), (b) the 30 year is not used as a primary hedge instrument against duration, nor is it materially a necessary embedded component in the half quadrillion in interest rate swaps (IRS) (whereas the 2, 5 & 7 tenors--and to a lesser degree the 10--are), and (c) the greatest demand for the 30 year will be the Fed itself when it restarts Treasury QE.

Since that post, the 10s-30s opened from 98 bps to an all-time, eye watering record of 125 bps, reaching its peak on August 10, 2010 which, not coincidentally is the exact date the Fed formally announced its next round of QE. Now that the spread has contracted to 106, it remains to be seen how much juice can be squeezed out of the trade, but we're sure Caron will capitulate when it's obvious post-facto the trend has once again reversed.

In a volatile economic environment, the worst strategy is long term trend following because there are, in fact, only short term trends punctuated with inflection points that are difficult for most to identify. As RW pointed out at EPJ Central over the weekend, retail investors have been burned once, and they will be as quick to jump out of bonds as they were out of stocks after the flash crash. Yet, we learn that pension funds--required to reduce risk by regulatory fiat--are salivating over a new 100 year bond issue from Norfolk Southern.

Norfolk Southern Corp .'s (NSC) reopening of its 100-year bond, first issued in March 2005, has launched at 5.95%, inside price talk of 6%, according to a person familiar with the sale. The sale has also been upsized to $250 million from original guidance of around $100 million.

The Norfolk, Va.-based railroad's new senior fixed-rate bonds, which come on top of the existing $300 million sold in 2005 and also maturing in 2105, are expected to be rated Baa1 by Moody's Investors Service and BBB+ by both Standard & Poor's and Fitch Ratings.

Bankers have estimated the issuer will need to pay a premium of roughly 0.75 percentage points more than what it would cost them to sell 30-year debt. The original deal from 2005 sold at par with an interest rate of 6%, and with a spread over Treasurys of 1.37 percentage points. Another 100-year bond the company sold in 1997 for $350 million, which was part of a $4.3 billion deal, had a spread of 0.97 percentage point over Treasurys.

Goldman Sachs is lead bookrunner on Monday's sale, proceeds from which will be used for general corporate purposes, according to the person familiar with the sale.

A spokesman for the issuer said its "decision to reopen the 100-year bonds was based on the current low [interest] rates, coupled with the strong appetite among buyers for them."

Bankers have been pitching century bonds selectively in recent weeks because Treasury rates are so low that issuers can lock in 100-year financing at reasonably attractive rates. At the same time, investors are sitting on piles of cash and looking to put it to work in corporate bonds, where where they are seeking longer-dated assets that give them higher yields.

Investors say that 100-year bonds aren't much more sensitive to interest rate moves than are 30-year bonds.

Century bonds were very popular earlier this decade and in the mid-1990s, but they aren't very liquid in secondary trading, meaning that they only make sense for certain types of investors. Life insurers and pension funds are the likely buyers and market chatter last week suggested there was around $100 million of capacity among these buyers for a 100-year bond. Investors prefer bond issues to be at least $250 million in size so they are eligible for inclusion in the Barclays Capital Aggregate Bond Index, like the Norfolk Southern 2105 bonds are.

Driving more pension fund interest will be the Pension Protection Act of 2006, which Michael Collins, senior investment officer for Prudential Fixed Income, said over time will encourage pension fund managers to minimize risk between their assets and liabilities even more than they do now.

Not to mention the unknown ramifications from the Frank-Dodd bill, which will keep DC bean counters busy for years tinkering with what's left of the economy. One might think that 100 years would be the ultimate duration, but it is not. Since (officially) 1751, the British government has been paying perpetual interest on consolidated annuities, or Consols. Andy Kessler wrote of them ten years ago:

In April of 1721, a plan was agreed on to fix the South Sea problem. Remember, the members of Parliament were complicit in the scheme; it was their debt that was being swapped for South Sea Company equity. The plan was called a consolidation. The government would swap shares of the South Sea Company for a piece of paper that would pay 3% interest forever. That’s right, forever, a perpetual annuity that paid out interest year in and year out. In 1726 came the Three Per Cent Bank Annuity, and in 1751, the Consolidating Act gave Parliament the power to issue these instruments, or consols, short for consolidation. England was relieved of the burden of paying back big money in 1721, in exchange for an agreement to pay interest every year. They still pay interest on these consols, the interest rate fluctuating with the market.

The odd effect was that English investors became very risk averse. Burned by equity and now guaranteed interest payments forever, the store of wealth became the guarantee of interest, which put a dagger through the heart of risk capital. In the 1870’s, the British were wealthy and America was poor. Undersea telegraphs opened America to British capital markets, and tons of money flowed to the U.S. to finance the build out of the U.S. railroads. But rather than owning equity in these railroads, the British mainly lent money, still more comfortable with getting paid interest and their eventual money back, rather than take the risk in equity, 250 years after the South Sea Bubble burst. Even today, you find a much less developed venture capital business in England and all of Europe vs. the risk junkies of Silicon Valley.

So, we had an investment bubble that was created by the government, which then exchanged worthless investment paper it helped create for government guaranteed debt--debt it is still paying for 250 years later. Mark Twain seems more prescient every day. Yet, one thing is assuredly different this time, which is the global nature of the present serial bubble economy. With all asset classes approaching plus or minus one correlation and nearly all central banks in the competitive devaluation business, we're in danger of killing off risk appetite for generations worldwide. That is, unless we can correct the basic economic fallacies that are leading the most productive economy in the history of civilization off a cliff.