Hundred Year Bonds? Are You Kidding?

SoThe Wall Street Journal reports 100 year bonds are back.  As you can probably guess, I am not a fan...unless I'm an issuer!

Very simply, corporate bonds have two components to their value: time and credit risk.  Lending money for a long time should pay higher interest than lending money for a shorter period--there's fundamentally more risk involved.  (This is why the yield curve slopes upward.)  Then there's risk of default by the issuer.  This often means the greater risk of lending to a company than the US government.

By extension, bond holders are short a put on the equity of the company.  Why?  Straight bonds do not share in the upside of company performance.  Bonds will only perform as promised or worse.  Never better.  No CEO ever said, "Gee, we did really well, let's send some extra coupon payments to our debt holders as a reward." 

On the other hand, if the equity of the company goes to zero, that means you start eating into what the bond holders own.  That's downside.

So, back to 100 year bonds.  Chances are, one hundred year bonds will default.  There's no reason to believe any economy, on average, has a chance of surviving 100 years.  Look at history.  War, revolution, runaway inflation.  Something gets them.  Then, layer on idiosyncratic risk of individual companies? 

So wait a second, if this is so obvious, why aren't 100 year bonds priced so that they have equity like returns, since they own all the equity downside, and they own that risk, more or less, forever?

As the WSJ says, 100 year bonds in the past have been purchased by insurance companies with very long tail liabilities, (like life insurance.)  These guys should know they're short a put, forever.  Some may, some may not.  In either case their regulators, investors and rating agencies tell them to hold bonds; holding stocks has higher costs, both direct and indirect.  Therefore, even for a worse deal, they're better off holding "inferior" equity that they can legally call a bond rather than holding equity they have to disclose. 

Get it?  Okay, so will someone please give me a 100 year mortgage??  Hmmm...wait...way back in 2007 couldn't we call get our negative amortization option ARMs?  I guess I missed my chance.

Of course he saw it coming...

I'm am completely sick of hearing he saw it coming...nothing about this individual in particular bothers me, but we hear this refrain all too frequently after outlier events.  Making proclamations that unlikely disasters will happen is easy because, well, talk is cheap.

Making piles of money (John Paulson, anyone?) doesn't even prove the point, but it's a step in the right direction.  At least he placed the bet.  Betting that disasters will happen when the bets are cheap takes skill to price, luck to get right, and errors don't come cheap.

The problem remains, however.  If we're talking about rare events, we can't see enough to differentiate luck from skill.  How long do we need to watch an investor to see if he can accurately predict one in fifty year events?  In financial markets, were correlations run very high, the answer, sadly, is a long, long time.

Where does that leave the academic in the SEC?  Sadly, I suspect ignored, with no authority, and a somewhat bigger audience than I have...but he won't be as entertaining!

Perspective on McKinsey

I hope most readers of this post have not read the book with this title.  All I will write is that the overleaf of this book (yes, this is the title of a book) says the following:

In a note distributed with every copy of Perspective, Marvin [Bower, founder of McKinsey & Company] reminded the recipient that the book was "privately printed and copyrighted by the Firm for readership only by Firm personnel.  I urge everyone who receives a copy not to give or loan copies to people outside the Firm."  Please continue to honor Marvin's request.

Today is a very sad day for McKinsey.  The have faced an incredibly complicated risk management problem for a long time, and until very recently, they've handled that risk well, or they've been lucky.