The Perils of the Ultra-Long View on Bonds
Last week, Italy began selling a new 50-year bond, following the lead of countries including Spain, Belgium, South Korea and France that have tried to lock in low interest rates in the past year. Ireland, Belgium and Mexico have gone even further, offering “century bonds” that won’t mature for 100 years. Corporate borrowers are testing the waters with “ultra-long” bonds.
The borrowers and lenders drawn to these so-called Methuslah bonds have good reason to feel that they are on solid ground: Such debt been around for centuries and has often been fruitful.
That’s the good news. The bad news is that the historical record indicates that any 21st-century mania for these bonds could end in tears.
The Dutch are often credited with developing many of the building blocks of modern finance: the first modern stock exchange, the first central bank and many other innovations. They were also the first to issue a new kind of debt: the perpetual bond.
As the name indicated, it had no maturity date. Instead, it simply paid a healthy rate of interest forever, though most of these bonds had some provision that enabled the government (or municipal authorities) to call the loan and redeem it.
The idea wasn’t as crazy as it might seem today. Year after year, the Dutch government would pay interest on its debts, making these bonds a great investment for the long haul -- the very long haul. Yet most of these didn’t run forever as governments exercised the redemption clause when it was deemed convenient to do so.
Still, some of these instruments are still paying interest. Last year, Yale University collected $153 in back interest on a perpetual bond issued by the Water Board of Lekdijk Bovendams in 1648 to finance the repair of a dike. (To be sure, Yale acquired the bond for its Collection of Historical Securities in 2003, not as a fixed-income investment for its endowment portfolio.)
When the Dutch-born William of Orange toppled Britain’s King James in the Glorious Revolution of 1688, he brought along his native country’s financial innovations. The Bank of England was chartered a few years later, and not long after that, the British government began issuing perpetual bonds.
In 1751, the British government converted all of its outstanding debt into new perpetual bonds called Consolidated Annuities, though they were soon known simply as “consols.” They paid 3.5 percent interest, and could remain outstanding forever, or until the government decided to redeem them. In fact, in succeeding years, the British government periodically converted these bonds into new kinds of consols, a practice it used to help finance World War I, among other spending. (Last year, it redeemed many of the outstanding consols to much fanfare.)
The U.S. also issued perpetual bonds, beginning with Alexander Hamilton’s consolidation of the federal debt in 1790. But eventually, debt with fixed maturity dates replaced these instruments, though perpetual bonds remained part of the mix for much of the 19th century.
When the U.S. government proved unable or unwilling to issue Methusalah bonds, corporations, particularly railroads, proved more than happy to fill the void. Sidney Homer and Richard Sylla, co-authors of the landmark "History of Interest Rates," noted that in the second half of the 19th century, the corporate debt of railroads tended to run to 50 or 100 years. One source concluded that two-thirds of all railroad debt issued in the 1890s ran 50 years or more.
In some cases, maturity dates on corporate debt reached so far into the future as to make them de facto perpetual bonds. The West Shore Railroad of New York issued a $1,000 bond that matured in the year 2361, which just happened to be the year its lease to the New York Central and Hudson Railroad Company expired.
And then there was the Elmira and Williamsport Railroad Company, which issued bonds in the year 1863 that it promised to repay in full on Oct. 1, 2862, or 999 years later. But the railroad only lasted a little over a century, closing down in 1972. Investors who had bet on the long haul got stiffed.
This was a common fate of many of the long-term railroad bonds. When they were first issued, it seemed likely that the railroad would forever dominate the U.S. economy. But by the early 20th century, the railroads began their decades-long decline as the automobile flourished. As a consequence, railroads could no longer place 100-year bonds and other novelties; investors realized that too much could change over a few years, never mind a century.
The 1930s brought the cruelest changes of all for holders of bonds. Until then, most bonds, both public and private, paid their principal and interest in gold or silver coin. With the Great Depression, governments around the world abandoned the gold standard. The change left open the question of whether governments would honor their promises, or would they pay bondholders in depreciated paper money, whose value, present and future, was at the mercy of arbitrary officials and events?
In the U.S., President Franklin Roosevelt issued an executive order banning the private ownership of gold and Congress passed a joint resolution relieving debtors of any obligation to repay their debts in gold -- including the biggest debtor of all, the U.S. Bondholders cried foul, of course, and in 1935 the Supreme Court heard their case. It declared that joint resolution was unconstitutional, but then simultaneously argued that bondholders were not, in fact, entitled to relief. In the end, bondholders got paper, not gold, for their pains.
None of this could have been foreseen when investors snapped up perpetual bonds, century bonds and all the other long-term debt that had seemed like such a good deal in the 19th century. Now, when a railroad bond -- never mind a Treasury bond -- came due, it got paid back in paper dollars that lacked the purchasing power of the dollars of yore.
From this point forward, investors generally eschewed Methuselah bonds because they realized that with governments and central banks in full control of the money supply, the future had become a lot less certain. President Richard Nixon’s final abandonment of the gold standard in 1971, followed by the inflationary pressure of that decade, left most investors leery of putting bets on the very distant future.
So why do Italy and other nations believe investors are now ready for long-term bonds? For one, there’s always a tendency to assume that present conditions will hold forever. And in the past few years, central bankers haven’t had much success generating inflation. That may have led some of the more credulous investors to assume that things will never change, making a low-interest bond that runs for 50 or even 100 years seem like a safe bet.
Moreover, investors chasing yield simply don’t have many options right now, with interest rates on sovereign and corporate debt close to zero, or in some cases, negative. In such an environment, they may believe that the only way to secure a low-risk positive yield, no matter how tiny, is to go long -- really long.
But that’s shortsighted. Before investors grab these bonds in their maniacal quest for value of any kind, they should remember that when it comes to bonds and interest rates, a century is an eternity. The last 100 years were filled with profound disruptions to the economic and political order, with direct implications for the bond markets. The next century will be no different.
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