With interest rates so low, the temptation to look beyond any reasonable time horizon can be strong. Also because, for some years now, the number of very long-term government bonds has significantly increased: governments are taking advantage of the low cost of debt (read: low interest rates) and are lengthening the duration of public debt. And look, we're talking about highlander maturities, even over fifty years.
Although they were created mainly to meet the needs of institutional investors such as insurance companies and pension funds, these bonds often attract the attention of savers, due to their relatively attractive yields to maturity compared to those of other government bonds. However, to avoid decisions that you will bitterly regret later, it is good to have a clear picture of the real nature of this type of investment.
Where does the bond yield come from?
Let's open the black-box of a bond's yield to maturity. What do we find inside?
The yield on a bond (government or otherwise) can be roughly broken down into the following factors:
- expectations about future inflation because whoever buys the bond does not want the profit to be eroded by inflation;
- the expected real return which compensates the bondholder for the unavailability of money;
- the default risk premium which compensates whoever buys the bond for the risk of not seeing the money back;
- the uncertainty related to the estimate of the previous quantities (for convenience we will speak of "margin of error", probably small).
That's the theory. And then there is the practice, that is the market.
We can find out how a long-term return breaks down. In fact, the main factors that determine the yield of a bond can be estimated with a good approximation by obtaining information from the derivatives market. To estimate the expected inflation we used the estimates implicit in the Inflation Swap (derivatives on inflation), while the default risk premium is obtained from the quotations of the CDS (in full: Credit Default Swap, i.e. derivatives that insure against the risk of default). Then, with a bold subtraction, the real return is obtained (also taking into account the margin of error).
The factorization of longer-term bond yields across major European markets can be surprising:
Think about it.
The real interest rate
Let's go to the root of the idea of the real interest rate: the real return is what the saver should get "in exchange" for depriving him of the money with which he could buy goods or services. Therefore, if the real return is negative, it means that one does not want to be remunerated for this deprivation, but rather one is willing to pay to give up the money (!!!).
In other words, a negative real return implies that, if you think about a good or service, you prefer to enjoy it in the future rather than today. And when you think about a future date, you realize that you prefer a date even further in time. And so on, ad infinitum.
Do you think it makes sense? Answer yourself.
Now perhaps the picture is clearer, but we still have to talk about the risks.
The risks
Those who invest in bonds of this type face two types of risk:
- the risk of fluctuations in the price during the life of the security, also called duration risk;
- the risk of default, linked to the possibility that the issuer is unable to repay the debt.
Duration risk
Against a zero real return, the risk of undergoing strong price fluctuations exists and can have a strong impact.
Default risk
With an effort of concreteness we can say we are quite certain that within a year governments will be able to repay our credit with a fair probability (some more, some less). But, extending the time horizon to fifty or a hundred years, i.e. the entire life cycle of these bonds, are we still ready to put our hand on the fire on the improbability of a government default?
The risk of default in Italy
For Italy, the data ranges from alarming to ridiculous: the probability of default of 5,5% in one year (very high, in our opinion, too much) swells to over 90% in half a century. But also take quiet Austria: the probability of default over the life of the bond is 34,4%. Now if you knew that the probability of being eaten by a tiger is 34,4%, would you take a walk in the jungle?
And that's the real point: think carefully before buying such bonds. Hoping it is clear that looking at the level of yield to maturity is not enough to decide whether the bond is attractive or not: behind the yield there is a complexity that cannot be underestimated, in particular the risks that determine such an attractive yield.
SOURCE: Advise Only
