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Don Coxe -- This Week

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Macleans -- Column

The long-bond shortage -- DONALD COXE

The notation "-30-" is, or was, the way copy editors at newspapers marked the end of a story. I recall when the Toronto Telegram ceased publication, the headline on its last edition was simply "30." It was the end of the Tely, but, as we would swiftly learn, the beginning of the Sun. This time, it is a suitable marker for the ending of one long-running story and the beginning of another.

Last month, the U.S. treasury department stunned Wall Street with the announcement it was "suspending" issuance of 30-year treasury bonds, the so-called long bond. It handled this momentous announcement sloppily, revealing it to a group of reporters an hour before issuing a press release, thereby letting some big traders reap huge profits by buying existing long bonds.

What ensued was the biggest rally in long-term bonds since the stock market crash in 1987. Existing long bonds leapt 5 8/32 points, as yields fell from 5.32 per cent to 4.87 per cent (because bond prices trade inversely to yields).

A casual reader would conclude the drop in long-term interest rates was not the real story: it was the latest blundering of Treasury Secretary Paul O'Neill. Mr. O'Neill suffers from three disabilities: first, he succeeded Larry Summers, a well-regarded secretary; second, he comes into office two years after the resignation of Robert Rubin, widely considered one of the greatest treasury secretaries since Alexander Hamilton; third, he is politically tone deaf. (After the World Series, when gentleman Yankee Paul O'Neill retired, pundits observed that the wrong Paul O'Neill was retiring.)

The casual reader misses the important story: the plunge in U.S. long-term interest rates does more to help the beleaguered U.S. economy than all the stimulus packages considered by Congress. The long and the short of it is that long-term interest rates are far more important than short-term interest rates to homeowners and to corporations considering capital spending. Together, those over-indebted sectors constitute approximately three-quarters of the economy. Substantial assistance to them is substantial assistance to the U.S. -- and the world -- economy.

U.S. homeowners have responded to the bond boom by refinancing their mortgages at record rates: the lowest interest rates for fixed 15- and 30-year mortgages in a generation and the greatest number of mortgages being refinanced. (An American homeowner with an acceptable record of meeting monthly payments can refinance his or her mortgage at any time without notice, simply by paying the servicing charges.)

What few observers have noted is that the treasury's decision comes at a time when the financial world is beginning to face a new kind of challenge: a long-term shortage of long-term bonds. When I entered the investing business three decades ago, one of the first rules I learned about bond management was "the bond crop never fails." This was the grim reality in an era of soaring deficits and soaring inflation. The longer the term of the bond, the more vulnerable it was to inflation and to governments' insatiable demands for funds.

Since the Reaganauts and Paul Volcker vanquished inflation, long-term government bonds have been wonderful investments, even when the bond crop was bountiful during the U.S. military buildup. In the 1990s, inflation kept falling, and so did deficits, but the volume of maturing debt meant new long-term issues kept coming, albeit in smaller size.

Now, the crop has failed. That is a double whammy for pension funds, insurance companies and (would you believe?) lotteries. The liabilities of these organizations, which must account for future payouts, go up when long-term interest rates go down, so they are scrambling to get long-term products to fund those liabilities. What happens is a leap in what bond managers and actuaries call duration -- the sensitivity of a particular investment or liability to a change in interest rates. (A bond's duration reflects both its maturity and its coupon: a low-coupon bond has a higher duration than a high-coupon bond, because it takes longer for an investor to get back his or her money. Cash, on the other hand, has zero duration.)

Across the world, financial institutions with long-duration liabilities are wondering where they're going to get product. Apart from the U.S. and Canada (and the provinces), few governments in the world issue meaningful quantities of bonds with maturities greater than 10 years (with durations approximating merely 5.5 years). Meanwhile, deflationary forces are accelerating globally, putting further downward pressure on long-term interest rates. The U.S. Producer Price Index (PPI) fell a record 1.6 per cent in October; Japan's Wholesale Price Index fell back to where it was in 1979; Britain's PPI is down 0.6 per cent for the past year, the biggest drop on record.

The best asset during increasing deflation is a long-duration bond. The treasury is making such bonds collectors' items. These are the best of times for long-duration bond investors -- and the worst of times for money-market investors.

Donald Coxe is chairman of Harris Investment Management in Chicago and Toronto-based Jones Heward Investments.
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