Investment management

100-year bonds form a niche market, with companies and investors perennially trying to weigh the pros and cons of such very long-term debts. 44 such bonds were issued during the 90s (Exhibit 1), probably as a response to a drop in the yields on Baa corporate bonds to between 7% and 8% from a local high of approximately 10% in 1990. Taking Disney’s 100-year “Sleeping Beauty” Bond issue as a motivating example, we aim to analyze whether such century bonds are merely a novelty item or an indicator of a long term trend in investment management. 100-year bonds: Advantages to investors

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The majority of buyers of such bonds are insurance companies and pension funds. This is because the very-long term income stream that these bonds offer is a good match for investors with very-long term liabilities. The long duration of century bonds helps these institutions to reduce their asset/liability mismatch while their exposure to interest rate risk is offset by the long duration of their liabilities. Also, buying such bonds is a good way for such institutions to immunize their portfolio from interest rate risk, since the long-term stream of income helps them match their long-term cash outflows.

The biggest advantage of 100-year bonds is their tremendous convexity. As shown in Exhibit 2, Sleeping Beauty has a much larger convexity than Napping Beauty, which is identical to it except for a shorter maturity. That is to say, the relative rise in price of Sleeping Beauty compared with Napping Beauty given a downside shock in interest rates is significantly higher than the relative fall in Sleeping Beauty’s price when interest rates rise by the same amount.

Generally speaking, a 100-year bond will significantly outperform a 10-year bond with the same coupon rate when yields fall, while it will underperform a 10-year bond to a much lesser extent if yields rise by the same amount. Risk Factors However, given their extremely long maturity, the risk taken by the bondholders is much greater than that of a holder of a 30-year or less bond. The primary reason for that is the much greater sensitivity of a century bond to changes in the bond yield; that is to say, its duration is usually very large.

The great exposure of century bonds to interest rate risk is demonstrated by the results of question 4 in the attached excel file. An increase of the interest rate by 10 base points provokes a 1. 32% decrease in the price of the bond, almost two times the decrease that the same change in the interest rates would cause to the price of a similar 10-year bond. Hence, the interest rate risk is quite high.

Despite the fact that formally century bonds are a form of debt, some would claim that from a riskiness point of view they are closer to equity securities. Advantages to issuers Studies about the century bonds that have been issued indicate some common characteristics about their issuers. To begin with, these bonds do not have sinking fund requirements [1]. This is an indication that the firms issuing such bonds are large institutions, exhibiting more publicly available information and, therefore, low information asymmetry.

At the same time, a sinking fund requirement could effectively reduce the maturity of such a bond, contradicting the original intentions of issuing such a long-term debt. Studies such as Diamond [5], [6] and Stiglitz & Weiss [7] indicate that firms have incentives to issue debt with longer maturity when liquidity risks are low. Again, large firms tend to have lower liquidity risks and should be able to issue debt with long maturity to reduce the cost of refinancing.

Finally, for investors to participate in such a long-term borrowing the company issuing the bond should be credible, and therefore, have a low default risk. Using the debt-to-equity ratio to measure the default risk of a company, we reach again the conclusion that large firms are more likely to obtain such long-term financing. The main reason behind issuing such long-term debt is taking advantage of low interest rates appearing in the credit market, while matching the asset base. An interesting fact is that century bonds offer tax benefits to their issuers.

To illustrate the importance of these benefits, we can take into account the fact that approximately 82% [2] of the companies that have issued such bonds included an option to either redeem or shorten the maturity of the century bonds if there would be any change in tax laws to eliminate the tax deductibility of the interest payments of these bonds. The “Sleeping Beauty” bonds The Disney “Sleeping Beauty” bonds pay 7. 55% in annual interest, with the principal to be repaid in the year 2093.

Therefore, each $1,000 bond would entitle its owner to $7,555 in interest over its life. From this perspective, it seems that investing in these bonds is a great opportunity for whoever would be willing to bear the risk of such a long-term debt. However, there is a point of great differentiation in the Disney bonds, compared to other long-term debts such as the Coca-Cola bonds – the 1993 Disney bonds have a 30-year call provision, meaning that Disney can buy back the bonds in 2023. The callable nature of the bonds is discussed in the following section.