Long-dated corporate bonds, with maturities greater than 15-years, used to trade against the off-the-run 30-year U.S. Treasury or ‘Old Bond’.  That long standing market convention was called into question in January 2020 when the U.S. Treasury announced it was dusting off a forgotten part of the government yield curve.  For several years, the U.S. Treasury had been investigating ways of extending their funding profile, including issuing ultra-long bonds ^[1].  They sought input from market participants, including the Treasury Borrowing Advisory Committee^[2] and concluded that reinstating the 20-year bond (last issued in 1986) was the best alternative to effectively finance the growing deficit.  The goal was to lock in low long-term rates while meeting market demand (primarily from liability driven investors) which would allow for issuance in a “regular and predictable manner in benchmark size”.  While the decision to reintroduce the 20-year bond was anticipated, the timing caught the market off guard.  Before the ink dried on the announcement from the Treasury, speculation began about a new paradigm of benchmarking 20-year corporate bonds to the 20-year Treasury.

The hiatus of the 20-year Treasury issuance left the rates market without an on-the-run benchmark presenting a challenge to the dealer community in hedging their interest rate exposure; as a result this led to the accord to trade 15+ year corporate bonds to the ‘Old Bond’.  The reintroduction of the 20-year bond would reduce these complexities and pave the way for how these long dated corporate bonds would trade in the marketplace.  Before any changes to the existing trading methodology were to be made, market participants wanted to get comfortable with the market dynamics and liquidity in the newly issued Treasuries.  Market optimism ran high in that the new “benchmark” Treasury would highlight the value in that part of the corporate curve and improve overall liquidity.  Not soon after the news, global economies fell to their knees on the growing risk of the COVID pandemic and thoughts of the 20-year roll quickly moved to the back seat.  For one, liquidity all but dried up for off-the-run bonds, even U.S. Treasuries!

With the turn of the calendar to 2021 and risk markets long past stabilization, the potential for transition to a new trading convention came back to the fore.  After some experimentation during 2020 with pricing 20-year new-issue corporate bonds against 20-year Treasuries the momentum began to pick up steam in the early months of 2021.   The market reached an inflection point in February where the primary market exclusively priced to the 20-year.

Figure 1: Primary issuance priced off 20-year Treasury 

Source: BAML as of May 2021

It was at this time the market knew a change was needed amidst the growing confusion with the differing conventions for primary and secondary markets.  After some initial strife amongst the market makers regarding the timing of the switch, consensus was eventually reached to transition bonds with maturities between 16 – 23 years beginning May 1^st.

Coincident with the broad agreement to roll to the new benchmark, the 20-year segment of the market outperformed with the most pronounced move in the 10s/20s relationship.  While higher all-in yields and the associated increase in demand from liability-aware buyers were partially responsible for the price moves, we do ascribe some of the 20-year outperformance to capturing the roll.

Figure 2: 20-year bonds have outperformed in 2021

Source: JP Morgan as of May 2021

What is the outlook going forward?

From a technical perspective we don’t see any meaningful impact as a result of the new trading mechanics.  20-year corporate issuance has been relevant for nearly a decade, largely as a way for mega-cap issuers to balance their liability profile to fund large-scale M&A activity.  The trend accelerated in 2020 with issuers extending maturities, taking advantage of historic lows in long dated corporate yields.  With the new pricing benchmark there is the potential to expand the issuer base from just the largest, most well-known credits to some of the less frequent issuers.  Trends in demand are expected to remain strong, particularly if our forecast for higher yields plays out.  Flows from dedicated long buyers (pension and insurance) remain in place and the relative attractiveness of U.S. yields should remain a tailwind to foreign buyers.  Additionally, we see some scope for greater participation from excess return investors with a more visible, transparent pricing convention and the ability to hedge with greater precision.

Some of the initial excitement surrounding the new benchmark was the potential to bring greater liquidity to the bonds that traded in ”uninhabited land”.  More specifically, legacy 30-year bonds that rolled down the curve to the off-the-run “doldrums”, a hodgepodge of issuers, coupons, dollar-price premiums, and deal sizes.  Further complicating matters, a large portion of these bonds are in the hands of insurance investors who have book yield and turnover constraints that reduces the availability of these bonds, hence the lack of liquidity in the first place.  Unfortunately, we don’t see the change in convention as a magic bullet and think some of the optimism was misplaced.  We expect the liquidity premium to trade within historical patterns that ebb and flow with the overall risk tone tightening in risk-on markets and widening in risk-off markets. 

Figure 3: Off the run discount

Source: BAML as of May 2021

Finally, we turn to valuations.  Looking at the 20s/30s curve for recently issued par bonds, current valuations look fair, trading in the 10 basis point context.  That said, given current dynamics in the rates market, 20-year corporates screen cheap offering almost 95% of the yield with 20% less duration risk when compared to their 30-year brethren.  This source of attractive yield per unit of risk should appeal to both liability-hedgers as well as active managers and support the likely continued growth in issuance.

What does this mean for liability hedgers?

With the reissuance of the 20-year U.S. Treasury, issuers and market participants sought the following benefits:

1. U.S. Treasury, as the issuer, found an efficient funding source
2. Market participants found an effective hedging tool for their activities in corporate markets, i.e. trading 15+ year corporate bond maturities against the newly “re-minted” treasury maturity, both for issuance in primary markets and for supporting trading in secondary markets
3. Corporate issuers would get a bargain on not only pricing efficiency but also a tool to optimize their balance sheet

While market volatility in 2020 was a setback for this earlier optimism, we believe that long-term investors will benefit most from this dynamic, especially as the short-term outperformance of the 20-year corporate yield curve is largely behind us.  For one, aggregate corporate defined benefit liabilities keep rolling-down the curve^[3], which means more pension interest rate exposure at the 20-year part of the curve.  Liability hedgers will likely welcome the additional market access afforded by this market dynamic to provide a more focused hedge.  

^[1] 40-50 year maturity

^[2] TBAC presents observations to the Treasury department on the overall strength of the U.S. economy as well as providing recommendations on a variety of technical debt management issues.

^[3] Liability payouts are due sooner i.e. cashflows to service benefits from pension plans are shortening in maturity:

• An average pensioner is older as pensions freeze/close plans to new entrants
• Actual mortality experience/revisions shows at least a temporary pause in life expectancy
• Offering lump-sums, or paying benefits sooner, to a subset of the pension plan population has also been a growing feature