Infinite Duration, Substantial Risk

US Dept of TreasuryInterest rates remain mired at historic lows.  Today, if you invest $100 in two-year Treasury bonds, our government will pay you less than a quarter in interest each year.  So wouldn’t it make more sense to put your money in a relatively new category of bonds that is paying 6% coupon yields–the equivalent of six dollars a year on that hundred dollar investment?

Wow!  Is there a catch?  When an investment pays much more than its competition, there is always a catch, and this time it’s a big one. The bond in question is called a perpetual bond, which means it has no maturity date.  You buy the bond, and hold it, and hold it, and because the company that sold you the bond never has to give you back your original investment, you may keep holding it. All other bonds eventually mature, and pay you back your initial investment.

With a perpetual bond, you can only get your money back if the company decides that it can get cheaper financing–if bond rates go down–which, of course, means that you will have to reinvest at a lower rate.  Heads, they win.  If rates go up, then the company simply lets you continue to finance its operations at the lower rate.  Tails, they win.

The other way to get your money back is to sell the perpetual bond on the open market.  But how certain are you that there are other willing buyers for a bond that might never mature?  You may have to accept a steep discount, dramatically reducing or even wiping out those tempting yields.  And if interest rates were to rise–and who doesn’t think that eventually bond yields will crawl up off the floor where they are today–you’ll find that any potential buyer is wary of overpaying for what could become a lifetime obligation.

This brings up the importance of a concept called “duration,” which is closely related to a bond’s maturity date.  Duration basically measures the amount that a bond’s value would rise or fall if interest rates were to fall or rise.  Money market funds and floating-rate bonds have virtually no duration; when interest rates move, they move with them.  Bonds with shorter maturities and/or higher coupon rates will have shorter durations than bonds with longer maturities and/or lower rates.

Why does this matter?  If interest rates were to rise by one percentage point, a bond with a duration of 5.1 (quite possibly a bond with a 6-year maturity or less) would lose 5.1% of its value.  A bond with a duration of 20 (quite possibly a bond with a 23 year maturity) would lose 20% of its value.

And a bond with a maturity that is essentially infinite?  Let’s hope the people who have reached for the tempting yields of perpetual bonds are capable of taking on the kind of risk you normally find at the high-stakes tables of casinos.

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