The question about when interest rates will rise has been a big question around here for several years, and we still don’t know.
Most investors are worried about rising interest rates and most people, including me, have been very surprised this year to see the yield on the 10-year US Treasury note fall from 3.00 percent to 2.29 percent, as of yesterday.
The direction of interest rates matters when you are trying to figure what term bond you want to buy – if interest rates are falling, long-term bonds are better and if interest rates are rising, short-term bonds are better.
The problem, as always, is knowing what rates will do before you buy them and both short and long-term bonds have risks.
Back in August, I wrote that a lot of people, including us a few years ago, were investing heavily in short-term bonds to avoid risk, but that can be a risky strategy too, in terms of opportunity cost. (Click here to see the article.)
This year, for example, the Barclays Aggregate, which has a 5.6 year duration as of Oct 31, is up 5.43 percent this year through yesterday.
The Barclays 1-5 Year Government/Credit index has a duration of 2.7 years as of Oct 31, but is only up 1.6 percent so far this year. That four percent advantage for the Aggregate will be a big cushion for when rates do eventually rise.
I thought about how we sweat over our duration (which is still a little shorter than the Barclays Aggregate) when I read an article in the Wall Street Journal yesterday about how Great Britain is only now, more than 80 years later, finally paying off some of the bonds that they issued to pay for World War I.
A few years ago, I read that Germany was finally paying off some of their wartime debt, but if memory serves me, they were paying off bonds issued in World War II.
The bonds being paid off today, were first issued in World War I, but were then restructured in 1932 with a 3.5 percent coupon rate and no maturity. They are so-called perpetuity bonds that, in theory, provide perpetual income. The duration for this kind of bond is close to 30 years – imagine the interest rate risk!
Of course, the interest rate risk on the war bonds pales in comparison to the credit risk at the time the bonds were issued. We know now that the British were on the winning side of history, but when the bonds were issued, I assume that many buyers weren’t sure who would win the war to end all wars.
Interestingly, the Brits are also paying back bonds that were issued as early as the South Sea Bubble of 1720 and the Napoleonic and Crimean wars and the Irish potato famine.
Why now? After all of these years, why bother paying back the bonds today? Because interest rates are so low. Although the yields on the soon to be retired bonds are below five percent, the 10-year British government bond, or gilt, is 2.24 percent.
What would Winston Churchill say? In a 1953 speech, he said ‘In finance, everything that is agreeable is unsound and everything that is sound is disagreeable.’
Low government bond yields: sound, but disagreeable. High yield junk bonds: agreeable, but unsound.