What does the Issue of 40 Year Government Security mean for your Savings?
The returns you get from you investments in provident funds and annuities depend on prevailing long term interest rates in the economy. The best indicator of long term interest rates is the yield on long maturity government bonds.
Given an expected cut off of 7.73% on the 40 year government bond, what can you expect from you savings in provident funds and annuities? The provident fund rate is fixed at 8.70% and with 40 year bond trading at levels of 7.73%, Provident rates are bound to come down as it will be impossible for the fund to generate 8.70% return that is guaranteed. The fund will then have to take extra risks in equities and lower rated corporate bonds to generate higher returns.
Annuity yields too will be low at closer to 6% as insurance companies have costs associated with annuities. In order to generate even 6% returns, insurance companies would have to invest in equities and lower rated corporate bonds.
The question you have ask yourself is whether inflation will stay below such rates for a period of 30 years to 40 years and that clearly no one has an answer.
40 year bond to be issued by the government
The government is issuing its first even 40 year maturity bond this week. The bond is issued as part of the government’s borrowing program for fiscal 2015-16. The bond will mature on 26th October 2055. Prior to this bond issue, the 8.13% 2045 bond maturing on the 22nd of June 2045 was the longest maturity bond outstanding. The 8.13% 2045 bond was issued in June 2015.
The issue size of the new 40 year maturity bond is just Rs 1 billion out of a total auction size of Rs 150 billion on the 26th of October 2015.
UK has been issuing long dated bonds as part of its government borrowing program. The UK government recently issued a 50 year bond at a coupon of 2.5% and the bond drew strong demand in the auction. The traditional buyers of long bonds are usually pension funds and insurance companies as they have long term liabilities.
In India too, the 40 year bond will see strong demand as traders look to make short term profits on buying in the auction and selling it down later at lower yields. The bond will go into hold to maturity portfolios of insurance companies and pension funds and also to some trading portfolios of banks, primary dealers, FIIs and mutual funds.
The coupon on the 40 year bond is likely to be around levels of 7.73% as it was traded in the When Issued market. The coupon of 7.73% is below the yield on the 8.13% 2045 bond, which is currently trading at levels of 7.79%. Is a coupon of 7.73% right for a 40 year maturity bond?
Bond markets tend to look at current market environment while fixing coupons on long maturity bonds. However as we all know, environment changes exponentially over a long period of time. Let us look at the coupon rates of 30 year bonds issued over the last fifteen years and see where the bonds are trading now.
Table 1 shows the issuances of 30 year bonds over the last fifteen years. In the 2002 to 2005 period, the coupon rates on the 30 year bond was fixed at levels of 7.95%, 7.50% and 7.40% and currently yields are at levels of around 7.80% to 7.90% on these bonds. 30 year bond issued in 2006 yielded 8.33% but bond issued in 2009 yielded just 6.83%. 30 year bond issued in 2010, 2011, 2012, 2013,2014 and 2015 yielded 8.30%, 8.83%, 8.30%, 9.23%, 8.17% and 8.13% respectively. The yields on these bonds are around 7.80% to 7.90% at present.
Bonds issued ten year back have seen yields trade at higher levels than coupon rates while bonds issued over the last five years have seen yields trend down. This can be attributed to inflation expectations prevailing when the bonds were issued and lower coupon rates meant that inflation expectations were low while higher coupon rates meant inflation expectations were high.