Who’s impressed with Osborne’s big bond?

17th March, 2012

“Mr Osborne will announce plans for the Debt Management Office to test market appetite for “super-long gilts” of 100 years or more, designed to cash in on investor confidence.”

– Financial Times, March 14

What’s this? George Osborne wants to show that his bond is bigger than the next man’s?

Something like that. The UK Treasury, unlike, say, Spain’s or Italy’s, is able to borrow from investors very cheaply. On the surface the chancellor appears to be thinking “instead of borrowing cheaply for two years, I could borrow cheaply for a 100 years, or perhaps for ever”. However, I think his real thoughts are closer to: “I wonder what might provoke every newspaper to mention that the UK Treasury, unlike, say, Spain’s or Italy’s, is able to borrow from investors very cheaply.”

Good politics, bad economics, in other words.

This is George Osborne we’re talking about.

Why is it bad economics?

Well, let’s be clear. Issuing long-dated bonds isn’t necessarily bad economics. But arguing that you can lock in today’s low rates for long periods of time is terrible economics. Today’s low rates are unusual. Why would investors want to extend them for a century?

There’s the Homer Simpson theory of bond investors, of course.

You’re thinking of Homer buying a car on credit and accepting the “CPB clause”?

Yes, the “crippling balloon payment”.

It turns a great deal into a terrible one, but postpones the day of reckoning.

As Homer said, “but that’s not for a while, right?”

I’ll admit that not every bond investor has shown signs of genius, but you can disprove the idea that investors will lend cheaply for ever by looking at bond yields today. Two-year bonds are yielding about 0.5 per cent. The 20- and 30-year bonds are yielding over three per cent, and the “War Loan” bonds, which never stop paying out, are yielding nearly 4 per cent. Just because investors will give you a cheap short-term loan doesn’t mean they will agree to the same rate at any maturity you care to name.

So Mr Osborne can borrow right now at 0.5 per cent, or lock in an interest rate of four per cent for a 100 years?

Pretty much, yes.

That sounds like a terrible idea. Why did you say issuing long-dated bonds wasn’t necessarily bad economics?

At a first approximation, it makes no difference whether bonds are short- or long-dated. Investors who want to lend money briefly can just sell long-dated bonds on the open market and get their money back at any time. Investors who want to lend money for long periods of time can keep reinvesting in a series of short-dated bonds. If either long- or short-dated bonds looked bad value, investors would vote with their feet.

So why are short-dated bonds so cheap right now?

Mostly because investors expect future short-term yields to be much higher, and are figuring they can lend for 10 years at, say, 2.3 per cent, or they can lend at 0.5 per cent now with the likelihood of being able to lend at 3 per cent later. It will all come out in the wash.

Why does anybody care about bond maturities, then?

I only spoke about a first approximation. The UK has benefited from having had a lot of long-term debt when the crisis began, which protected it from short-term panics. And there’s another consideration: in an uncertain world, bond investors will choose the maturity that fits their needs to reduce the risk of something unexpected happening. Some financial institutions like short-term bonds because they have flexibility even in a crisis; whereas pension funds will go for 20- or 30-year index-linked bonds because that matches the payments they have to make to pensioners.

Who likes 100-year bonds?

Nobody that I can think of. The National Association of Pension Funds has already said they are too long. But giant tortoises of the Galápagos can live for well over a century. Perhaps there is a market for Tortoise Bonds.

There’s a tree in California nicknamed Methuselah. It’s over 4,800 years old.

Methuselah Bonds! Now you’re showing some real ambition, although I am not sure that bristlecone pines have the same presence in the bond market as, say, Pimco. Still, who’s to say Mr Osborne’s prudence won’t earn the nation 5,000 years’ worth of credibility? Just show me where to sign up.

Also published at ft.com.

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