The yield on the 30-year U.S. Treasury bond is just 1.4%. That’s the lowest it’s ever been, by far, which is why many people—including many Barron’s readers, if my email inbox is any indication—believe this is a great time for the federal government to issue more long-term bonds to “lock in” these low rates for the future.
Intriguing new research from University of Oxford economics professor Martin Ellison and Andrew Scott of the London Business School suggests however that long-term debt is a needlessly expensive way to fund the government compared to short-term debt. Borrowing long means spending more money on interest payments, which ultimately means issuing more debt compared to borrowing short. Long-term debt doesn’t even reduce “operational risk” because the benefits of “stable” funding are consistently offset by higher refinancing needs and higher price volatility.
Ellison and Scott make their case with a new dataset tracking the prices and terms of every individual British government bond since 1694. They use this information to track the returns earned by investors over time in different securities, because those returns represent the true cost of debt financing from the government’s perspective.
Capital gains (and losses) experienced by investors are equivalent to how much money the government lost (or made) by borrowing long term before yields fell (or rose). Rising interest rates after World War II, for example, meant that long-term bond prices fell, which lowered debt service costs and offset the burden of continued coupon payments. After the financial crisis, by contrast, the sustained decline in short-term interest rates and the long maturity of the government’s debt meant that the government effectively paid an additional 1.1% of gross domestic product each year to investors on top of the scheduled bond coupons.
Debt managers need to know which effect is more common, and which is larger. Ellison and Scott first look at the U.K.’s experience in wartime. It turns out that investors’ return on debt was only slightly lower during conflicts, when deficits were large, than during peacetime, when surpluses caused the debt to fall. Borrowing long-term to finance military spending provided some “fiscal insurance,” but only a little.
In financial crises, however, the government consistently lost money by borrowing long term. On average, the combination of weak growth and subdued inflation during and immediately after financial crises pushed up real investor returns on British sovereign debt during those periods by 4.5 percentage points each year on average compared to non-crisis periods.
As Ellison and Scott put it: “The favorable movements of long bond prices in wars make long bonds useful but limit providers of fiscal insurance against military expenditure shocks, [but] the adverse reaction of their prices during financial crises undermines their ability to insure a government facing a broader range of shocks.”
Across the entire time sample, there is basically zero relationship between changes in bond prices and changes in the government’s budget deficit, which means that there is no advantage to “locking in” long-term funding.
For example, if the U.K. had only issued three-year zero-coupon gilts between 1914 and 2017, “the market value of debt relative to GDP would have been 23.6 percent lower.” In other words, they say, “short bonds lead to lower costs for the majority of periods, with only the 1970s being a period where issuing longer bonds regularly dominates” because the 1970s were characterized by rapidly accelerating inflation at a time when investors weren’t expecting it. According to them, “the operational risk from refinancing is minimized when the government issues 2-year and 11-year bonds in the proportion 3:1, an average implied maturity at issuance of around 4 years.”
The simple explanation is that long-term debt almost always carries substantially higher interest rates than short-term debt. After all, savers need to be compensated for the risk of locking up their principal for sustained periods of time. While the size of this risk premium changes over time, it’s almost always positive. (The slightly more complicated explanation is that short-term debt also allows governments to quickly refinance into lower rates after temporary periods when interest rates are high.)
The U.S. 30-year yield may be only 1.4%, but the 2-year Treasury note currently trades at just 0.15% and even the 10-year note has a yield of only 0.65%. At those yields, that means the cost to the Treasury of insurance against higher interest rates more than 10 years from now is equivalent to 0.75 percentage points each year for a decade. The only reason it would be worth paying that price is if Treasury officials expect a lot more inflation than investors do.
Write to Matthew C. Klein at matthew.klein@barrons.com
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July 05, 2020 at 07:00PM
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Why the Government Should Favor Short-Term Debt and Not Lock In on Long Bonds’ Low Rates - Barron's
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