The Really, Really Long Bond

For the time being, income investors are probably better off being owners than lenders. Many solid US companies are paying dividend yields of 2%, 3% and 4%. Short-term corporate bonds, meanwhile, yield next to nothing. The bond market is getting nuttier by the day – offering ever-lower interest rates at ever-higher risks. The recent spate of 100-year bond issues illustrates the point.

100 years ago, back in 1910, Zeppelins were all the rage. After patenting his design at the turn of the century, Count Ferdinand von Zeppelin had successfully made his rigid airship the one and only legitimate form of flying transportation. True, in 1910 there were some country boys named the Wright Brothers tinkering with terribly unstable gliders and propeller flying machines. But the Zeppelin was the standard. You see, it just made so much more sense at the time…make a big cylinder out of the thinnest metal possible, fill it with cow intestines then fill those intestines with light, flammable gas; power the thing with a fire-breathing engine to float thousands of feet above ground… What’s not to love?

While the Wrights toiled on their design, Zeppelins ruled. The world’s first airline, DELAG, flew Zeppelins exclusively. Zeppelins had conducted commercial cargo and passenger flights long before Americans risked their lives or merchandise with airplanes as we know them today. Zeppelins were a hit with the German military too, while in 1913 the American Army deemed the Wright model C “dynamically unsuited for flying.” They had this nasty way of nose-diving and killing everyone on board, the Army said, and soon after discontinued its business with the Wright Company.

So imagine this: You’re an investor, alive and well in 1910. You have to chose to lend to one of these companies money for the next 100 years… Do you write Count Ferdinand a century bond, or do you loan the money to the Wright Brothers?

The Wrights, as you know, had the right idea, even though the opposite seemed true at the time. Had you lent them money 100 years ago, there’s a chance you’d get it back today, plus interest. Their company became the largest aircraft manufacturer in the world by the end of World War II and is now known as Curtiss-Wright, a publically traded component manufacturer with a $1.4 billion market cap.

Count Ferdinand and his Zeppelin, however, slowly floated into an antiquated reality until the Zeppelin industry – quite literally – crashed and burned into New Jersey in 1937. Your best shot at getting your 100-year Zeppelin bond cashed today would be mugging the crew of the Goodyear Blimp.

The moral of the story: The vast majority of people, your editor included, don’t know squat about what the world will be like 100 years from now. We can guess, but little more. And in the “game” of investing, guessing is a scary thought. Better to know for sure, or as close to sure as you can get.

Yet, the 100-year bond is now officially back in vogue. The last three months have seen the trifecta of century bond offerings:

  • A stalwart American company: Norfolk Southern, arguably the oldest railroad operation in the US, raised $250 million in August when it sold bonds to investors due in 2110.
  • A powerful multinational bank: AAA-rated Rabobank raised $350 million a month later selling 100-year bonds of their own.
  • A struggling sovereign state: Mexico borrowed $1 billion in early October, which most of its lenders won’t see until this time in 2110.

Here’s the best part: For the privilege of borrowing “investor” capital into the next century, not one of these issuers paid over 6%.

This is the latest chapter in the most powerful trend in investing at the moment: the hunt for yield. Investors are so hungry for high-yielding, stable return they are willing to take outlandish risks…like buying a 100-year bond from a government that has suffered two major currency crises and one sovereign default during the last 30 years.

Why? As with most financial bubbles, ask the Fed.

Having pushed interest rates to 0%, the Federal Reserve has made the cost of borrowing money around the world its cheapest…ever? Microsoft recently sold a wave of three-year bonds at a stunningly low 0.8% yield. Under such low-rate circumstances, companies can raise cash for almost nothing. Investors, meanwhile, are left gnawing on meatless bones… If you can finance your retirement on 0.8% annual returns, please tell us your secret.

So the average investor has to choose between a savings account that yields 1%, bonds that might yield even less and a stock market that just suffered its biggest collapse since the Great Depression.

This explains most investment trends of 2010. Appetite for yield is why the S&P Dividend Aristocrats index is outperforming the S&P 3-to-1 this year. It’s why, according to Dealogic, US companies have sold a record $168.5 billion in high-yield bonds so far in 2010. And it’s why investors are willing to entertain the idea of letting railroads, banks and struggling states borrow their hard-earned dollars for a hundred freakin’ years.

But the same way there are two sides to every story, not all century bond buyers are foolhardy investors. In fact there’s a good chance that, should deflation worsen in the US, 100-year bond owners will be able to sell their bonds on the secondary market for a premium.

Here’s one example: Norfolk Southern Railroad has issued 100-year bonds before. As of this writing, it would cost an investor $1,110 to buy a $1,000 century bond Norfolk Southern issued in 2005. That premium to par value is a sign of investor demand…the same way stock investors pay insane earnings multiples for “hot” companies like Google. Even though overpaying for that Norfolk Southern bond will cut it’s yield from 6% to an effective rate of 5.3%, investors can’t find better yield elsewhere…or they’re betting they can sell those bonds to a greater fool down the road.

In bond trading parlance, income investors are getting pushed “out on the curve.” Rates for US Treasuries and short term, investment-grade corporate debt are so dismal that anyone seeking meaningful income (like over 5%) has to take on an unusual amount of risk. Either they must take on default risk by lending to sketchy companies teetering on bankruptcy. Or they must expose themselves to interest-rate risk by lending for obscenely long periods…like 100 years.

Maybe, 100 years from now, a railway from West Virginia to New York (or the coal that it’s carrying) will be as useful as the Hindenburg. What will become of those Norfolk Southern 100 year bonds then? Geesh, will the Fed even be around in 2110? It wasn’t in 1910. If the dollar makes it to 2110, it’ll be one of the longest lasting currencies in the history of the world… What will those bonds be worth if they have to be redeemed in Ameros? Or yuan?

These are all questions Norfolk Southern century bond buyers are willing to dismiss…for a measly 5.9%.

As Eric Fry and Bill Bonner have reckoned in these pages before, we may be witnessing a sort of “peak debt” in the investment world. Earlier we mentioned that remarkable bond issue from Microsoft. It’s worth adding, the company currently pays a 2.6% dividend. So if you were forced to buy its debt or its equity, which would you choose…three years of 0.8% and no chance of capital appreciation, or three years of 2.6% dividends and a stake in future earnings?

We’d sooner take our chances with a solid yield and an uncertain future than a bond coupon that inflation will certainly consume. We don’t exactly crave a stake in the company that brought you the Zune, but with bonds at 0.8%…what’s the point?

There is money to be made in bond trading, like always. But for investors looking for stable returns and substantial yields, corporate debt – or any debt for that matter – ain’t what it used to be. Unlike years past, corporate equity is now the source of the best income risk/reward ratios.

To repeat: income investors, for the time being, are better off being owners than lenders.


Ian Mathias
for The Daily Reckoning

The Daily Reckoning