I got sidetracked from my best and worst investment series by the GE saga. FYI, I updated the post with some better LTC data and showed the cherry picking was even worse than I thought! Anyway, today we will talk about the fools who bought 100-year debt from Argentina.
Argentina became independent just over 200 years ago. In those 200 years, it has defaulted on its debt eight times! The first default was in 1827, only 11 years after achieving independence! It’s unclear if there has even been a 30-year bond issued by Argentina that paid in full.
Yet, two years ago, Argentina came to market with a 100-year bond with an effective 7.9% yield. Naturally, investors tripped over themselves to buy it. It was 3.5X oversubscribed.
Why? The “logic” behind the bull case was, at a ~8% yield, you get your money back in 12 years, so you were only betting on 12 years without a default, not 100. Of course, that forgets that, if that was how it played out, you would have made a 0% return over 12 years, which isn’t something to brag about.
The truth is buyers had no intention to hold it for 100 years. I doubt most even held it for 100 days. It was a trade. If you believed Argentina was improving, then a 100 year bond gave you the most leverage to the story. And, for a period of time, the trade worked. By the end of 2017, the bond was up double digits. Everything was looking great!
Barely Made It Two Years
You can probably guess what happened next (if you haven’t read about it already). In last week’s primary elections, modern day Peronist Cristina Kirchner essentially came back to power which means the end of economic reform. The Argentine stock market fell nearly 50% (in $) in a day.
The 100-year bonds fared little better. They had already fallen to 75c on the $ before the election due to poor economic results (inflation is running ~50%). The election dropped the bonds to ~50c.
So much for 12 years without a default. It looks like we won’t make it to the third anniversary! Even if the election news was a surprise, it can’t be surprising that eventually something came along to crush investors in Argentina. Truthfully, it would have been surprising if nothing came along.
Temporal Differences
The only reason Argentina was able to issue is because there was a willing group of investors who ignored that this was a 100-year bond and traded it as essentially a short term derivative on the Argentine economy. The government was able to arbitrage markets by issuing long term debt to investors who had no intention of actually holding debt for the long term.
This was no bait and switch either. Everybody knew what was going on. Nobody knew who would hold the paper 10, 20, or 99 years from now, but nobody cared either. That was a problem for another day.
This is not dissimilar to what happens with M&A where short term arbitragers get more votes on whether a deal should go through than long term shareholders who will continue to own the stock after the deal closes. Activists often exploit this timing disconnect (I will have more to say on this in the future).
We also see this in the market for secondary offerings, where as long as some short term investors are willing to buy the stock at a discount, the deal gets issued, even if the great majority of investors wouldn’t want the company to issue stock at that price.
There are many other examples of these temporal differences, where there is a mismatch between the time horizon of the majority investor and the marginal investor. Yet, the marginal investor gets to set the price.
Fisher Theory
The first person to identify something like this phenomenon was the famous economist, Irving Fisher. Fisher explained one reason why the term structure of interest rates is upward sloping. His theory was that, if presented two equal financial returns, people would choose the one that paid them sooner. You might say he was the first behavioral economist!
My corollary to Fisher is that investors also have time preference regarding capital appreciation on investments. All else equal, investors will choose a short term return over a long term return.
In other words, say I have two investment options: one that produces a 10% return in a year and a second that produces a 10% annual return for five years. In today’s world, most investors will choose the first investment, especially if the second investment has volatility in its path of annual returns. Investors prefer the more immediate payoff to the compounding of the long-term payoff.
This may seem incongruous to the lay reader. Isn’t it harder to have to find a 10% one-year return five times than to just find one five year investment with the same return? Yes, yes it is. However, most professional investors are so laser focused on their annual performance (because that is what they get paid on) that they shortsightedly take the harder path. You need to have very patient money to ignore short term returns to focus on the long term.
Investment banks are well aware of these temporal dislocations and use it to help companies (and sovereigns) finance themselves at better terms. Most issuers don’t care that their paper ends up in the hands of people who don’t know or care what their company does. They’re just happy they saved a few basis points. Thus, the cycle continues.
Is There A Solution?
I don’t have an easy answer to change the market structure, but these differences in time expectations are a problem. Nobody should be buying 100-year debt at historically low interest rates. We need the return of something like the “bond vigilantes” to just say no.
There is a lot of capital being misallocated by issuers exploiting the time arbitrage. It doesn’t do anyone any good when deals that 90% of investors don’t want can come to market because there is always a willing 10% to fill a book. A lot of this 10% is essentially funded by cheap leverage from easy money created by loose central banks worldwide, but that is a whole ‘nother topic.
The lesson for today is bad ideas are able to get funded, even when most people know they are bad, because they may be good tomorrow, before they turn bad the next day. This is not good for our economy. It results in suboptimal allocation of capital and, worst case, creates future zombies that plague the economy for decafes (I see you Japan!).
We need better ideas to prevent these deals from coming to market under false pretenses. My guess is they involve some sort of liquidity penalty that makes it harder for flippers to sell or gives long term holders some sort of veto rights. I’m happy to take any suggestions for possible solutions.