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Why stop at 100? The case for perpetuities

Summary:
Issue 100-year Treasurys, advocates the Wall Street Journal.  It mentions a short note deep on the Treasury website thatTreasury’s Office of Debt Management is conducting broad outreach to refresh its understanding of market appetite for a potential Treasury ultra-long bond (50- or 100-year bonds). My 2 cents: Why stop at 100? Issue perpetuities! (I wrote a whole paper on this a while ago, ...

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Issue 100-year Treasurys, advocates the Wall Street Journal.  It mentions a short note deep on the Treasury website that
Treasury’s Office of Debt Management is conducting broad outreach to refresh its understanding of market appetite for a potential Treasury ultra-long bond (50- or 100-year bonds). 
My 2 cents: Why stop at 100? Issue perpetuities! 

(I wrote a whole paper on this a while ago, if you want lots of detail and answers to practical questions. Unfortunately the Treasury website does not say how to send in suggestions, and nobody outreached to me, so this blog post is it.)

Perpetuities are bonds with no principal payment. Each perpetuity pays $1 forever.  If interest rates are 3%, to borrow $100, the government would sell three perpetuities, and then pay investors $3 each year. When the government wants to pay back the debt, it simply buys back the perpetuities on the open market.

A 100 year bond is almost a perpetuity. If the government issues a $100 100 year bond at 3%, only 100/(1.03)^100 = $5.20 of that value comes from the $100 principal payment. 95% of the value of a 100 year bond is already in the stream of coupons. For the investor, they are practically the same security. In particular they have nearly the same sensitivity to interest rate changes.

But perpetuities are better. Most of all: Perpetuities would be much more liquid -- easy to buy, sell, and use as collateral.  The reason is simple. Once 100 year bonds get going, there would be 100 separate and distinct issues outstanding. The 2123 2.6% 100 year bond is a different bond from the 2124 2.7% 100 year bond. If a dealer has an order for the first and an offer for the second, he or she cannot make the trade. If you borrow and sell short the first, you cannot deliver the second in return. This segmentation would make the markets for each bond thinner, and the bid ask spread larger. It would keep a lot of dealers and traders and market makers needlessly in business, which may  be one good reason the financial industry seems largely against the idea.

Perpetuities, by contrast, are a single security. When the government borrows more next year, it is borrowing more of the same security.  There is one, thick, transparent, low-spread market.

A more liquid market would pay lower rates.  Much of the point is for the government to borrow at low rates. Much of the reason government debt has such low interest rates is that it is very liquid -- easy to buy and sell, the "safe haven" in bad  times and so forth. Government debt is somewhat like money, and like money pays less interest in return for its liquidity. Well, then, the more liquid the better!

A 100 year bond would make sense if there were a group of investors sitting around who really wanted to have $3 coupons for 100 years, and then $100 exactly in 100 years, not 101 years, and they were not planning to buy or sell in the meantime. That is not remotely the case. Long term bonds are actively traded. Perpetuities match the varied investment horizons of ultimate investors, and by being more liquid are more flexible.

There is plenty of historical precedent. Perpetuities actually came before long-term bonds. They were the cornerstone of UK finance for the entire 19th century.

One can raise a bunch of practical objections, and if you have them go check out the paper.

Lower costs? The WSJ only advocates 100 year debt on the notion it would give the Treasury a lower borrowing cost when yield curves are inverted. This is a good argument, but more difficult and subtle than the WSJ lets on. The current yield is not the lifetime cost.  The 100 year cost of borrowing with short term bonds depends on what short term interest rates do in the future. If rates go up, it costs eventually more to borrow short. If rates go down it costs less, even if the current yield curve is inverted. In the benchmark "expectations model" yields have already adjusted so the expected cost is the same. The issue is the same to a household deciding between an ARM and a fixed rate mortgage. Even if the current ARM rate is higher than the fixed, if ARM rates go down in the future, the ARM could end up being better.

My paper was part of a conference at Treasury, published by Brookings.  I had a good debate with Robin Greenwood, Sam Hanson, Joshua Rudolph, and Larry Summers who wrote The Optimal Maturity of Government Debt (available here). They argued for borrowing short, not long. A the time the yield curve was steeply upward sloping, and in their simulations they opined that the chance of short rates rising and long rates declining to the point that the cost advantage would invert was small. The current reality has changed that conclusion as now it is the short rates that are higher.

Still, I think this is the wrong way to look at it. The Treasury is not in a great position to play bond trader and figure out where small variations in the yield curve reflect profitable opportunities.

Risk management. Like all investors, though, the Treasury's first question should be risk management, not profit. And there is a great risk facing the US Treasury. We are clearly going to run up a lot more debt before sanity sets in. Go look at the just released CBO Long Term Debt Outlook.

Why stop at 100? The case for perpetuities

Net interest is already large. What happens if interest rates go up? Yes, they are unbelievably low now. But nobody really knows why. Between "secular stagnation" and "r* has declined" and "savings glut" you can see economists making things up right and left. So, you should not have huge confidence that we will not  return to historically normal interest rates of the last few centuries, or moreover that we will never suffer the kinds of interest rate spikes that happen to highly indebted countries trying to roll over 100% of  GDP  or so debt in a recession,  financial crisis, or war. If interest rates rise sharply, the US Treasury, having borrowed  short, is screwed.  We bought the ARM at a teaser rate.

This,  to me, is the real argument that  the  government should issue lots more long-term debt; 100 years if needed (but please, only every 10 years or so!) or, much better, perpetuities. Buy the fixed rate mortgage, and you keep the house no matter what happens to rates. Let's keep the house. In this discussion with Greenwood et al, they argued that the chance of such an interest rate spike is low. Perhaps, but the insurance is cheap -- and with a flat or inverted yield  curve it's even cheaper.

Borrow long to buy insurance, not just for a good deal.

Update:

In response to a few comments. In the paper I proposed that the Treasury issue 1)  fixed-rate perpetuities -- a security that pays one  dollar forever -- 2) floating-rate perpetuities -- just like Fed reserves, the interest rate adjusts  daily  and the price is always exactly $1.00 3) indexed perpetuities  -- it pays one dollar adjusted for  the CPI (or one of its improved versions) forever. The first eventually replaces all long  term debt, the second eventually replaces all short term debt, and the third replaces TIPS.

The second is really more  important, and I'll do a separate post eventually. If the treasury offered a fixed-value floating-rate instantly transferrable security just like reserves, it would do wonders for the  financial system.



John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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