30-Year Bonds May Return, Will Investors?

Earlier this month, the U.S. Treasury Department said it may reissue 30-year bonds as the government grapples with financing record budget deficits. The long-bond program was suspended in October 2001.

The about face reflects dramatic changes in the nation’s geopolitical profile following the costly obligations of wars in Iraq and Afghanistan, the recession of 2001, President Bush’s massive tax cuts, and a proposal to privatize Social Security.

When 30-year bonds were eliminated in late 2001, the world was a very different place. The U.S. Congress predicted years of surpluses, which would eventually wipe out the national debt, and hoped to save money by shortening the average maturity of public debt and by no longer issuing higher-yielding long-term debt.

But after posting a handsome surplus of $236 billion in 2000, the fourth straight year of such surpluses, the government incurred deficits of approximately $400 billion in each of the next four years, including a record $412 billion in 2004. The figure is expected to reach $427 billion this year. Now, by proposing a return to 30-year bonds, the government appears to believe the deficit will continue to grow, exacerbated by baby-boomers about to enter into retirement.

With short-term interest rates steadily rising, the government is finding it more attractive to move federal debt away from short-term financing. Also, as the gap between short-term and long-term interest rates narrows, it makes more sense to borrow long. By issuing new 30-year bonds, the Treasury could reduce its cost of borrowing over the long term by attracting new investors, diversifying their issuance, and reducing their exposure to possibly higher short- and medium-term rates. Some European governments, including France and Britain, have already issued long-dated securities, even a 50-year bond, to meet the demand from pension funds for their ageing populations.

Assuming the plan goes through, the Treasury said it would conduct two auctions next year, the first in February 2006. Each would be valued at between $10 to $15 billion. A final decision on the issuance will come in early August, though many believe it is already a fait accompli.

James Cusser, sole manager of the $243-million Waddell & Reed Advisors Government Securities Fund/A (UNGVX) and the $676-million Waddell & Reed Advisors Bond Fund/A (UNBDX), said there will be great demand for these new 30-year bonds, “particularly from defined-benefit pension funds and insurance companies, who are seeking to match their long-term obligations with long-term assets.”

Brian Howell, co-manager of American Century Strategic Allocation: Moderate (TWSMX) and senior portfolio manager for taxable bond strategies, said he sees a “reasonable demand” for these new bonds from typical long-term investors, particularly as a duration instrument. “As a pure duration play, there is no substitute for these 30-year securities,” he said. “Bond fund managers would also likely invest in these securities — again, to add duration to their portfolios.”

Howell noted that while 30-year bonds are probably not ideal for individual investors, “they might appeal to some investors who are looking for long-term secure income, a little yield, and not much risk.” However, he thinks institutional buyers will form the bulk of investors for these new bonds.

“A big point for individual investors is that the 30-year Treasuries are a pure duration bet,” said Gary Arne, managing director, financial services and global practice leader for fund ratings & evaluations at Standard & Poor’s. “And since the 30-year Treasury is so long on duration, it offers less risk from a price and total return perspective when long-term rates are headed down, not up.” Arne added that most bond fund managers are currently “sticking pretty short now, most likely to avoid market price declines when long-term rates increase.” But so far this year, long-term rates have not moved, he noted.

“Most individual investors should not be buying 30-year bonds,” said Scot W. Johnson, lead portfolio manager of the $865-million AIM Intermediate Government Fund/A (AGOVX), and the $312-million AIM Limited Maturity Treasury Fund/A (SHTIX). “One of the roles bonds play in individual investment portfolios is to provide some stability to offset more volatile assets like stocks. When you start buying 30-year bonds, you limit the stability your bond holdings provide. For any movement in interest rates, you can expect 30-year bond prices to move twice as much as prices on 10-year notes. In exchange, you get only about 35 basis points more in yield. For me, that’s not a good risk-return trade off.”

One of the major themes in long-term bond investing, characterized as a “conundrum” by Federal Reserve Chairman Alan Greenspan, is that long-term rates remain at historic low levels, even as the Fed has steadily boosted short-term rates for the past year. As a result, the yield curve, the gap between short- and long-term interest rates, is flattening. No one, not even Greenspan, can explain why this is happening.