Austria’s 2086 Bond Flop: What It Means for Ultra-Long European Debt

Summary:

• Unattractive yield and insufficient compensation for risk to hold ultra-long duration. The Austria 2086 bond's 1.5% coupon and modest yield-to-worst fail to compensate investors for the significant duration risk, making it unappealing compared to shorter-duration bonds with better yields. This imbalance in risk and reward is why the syndication for the reopening of this bond ultimately failed.
• Investor preferences shifting due to the potential for a soft landing. Investors are increasingly cautious about ultra-long bonds, preferring shorter or medium-term bonds that offer better risk-adjusted returns, especially given the uncertain economic conditions stemming from the possibility of a soft landing, where the ECB might not be able to cut rates below 2%.
• Potential liquidity concerns. The lack of demand in the primary market for ultra-long bonds, despite current secondary market liquidity, could signal future liquidity challenges, leading to further hesitancy in both primary and secondary markets.

Austria’s 2086 Bond Reopening Fails Amid Investor Concerns Over Yield, Duration Risk, and Economic Uncertainty

Let's delve into Austria's unsuccessful attempt to reopen the sale of its 2086 bond. Austria aimed to proceed with a syndicated sale of its existing 2086 maturing bonds, which pay a 1.5% coupon (ISIN: AT0000A1PEF7). However, the outcome was a clear lack of investor interest. What drove this rejection?

Given the backdrop of declining inflation in the Eurozone and the European Central Bank (ECB) commencing its interest rate-cutting cycle, one might expect investors to eagerly extend duration by snapping up ultra-long European bonds like Austria’s 2086 and 2120 issues. Yet, that hasn’t been the case. Here’s why ultra-long duration is currently unappealing, particularly in the case of the 2086 Austrian bond:

1. Unattractive Coupon for Real Money Investors:

The 1.5% coupon offered by the Austria 2086 bond fails to entice "real money" investors such as insurance companies, pension funds, banks, and asset managers. These entities, which typically participate in bond syndications, are particularly focused on earning a positive carry. While hedge funds, who also participate, may prioritize total return, carry remains crucial for other players. For instance, they can achieve over a 3% coupon (ISIN: AT0000A33SK7) with Austria’s benchmark 30-year bond, which also limits their exposure to duration risk. In this context, a 1.5% coupon is simply not competitive.

2. Insufficient Compensation for Duration Risk:

The Austria 2086 bond offers a yield-to-worst (YTW) of 2.82%, which is about 30 basis points below Austria's 2030 bond and only 30 basis points above Germany's 2030 bond (ISIN: DE000BU2D004). Given that the Austria and Germany 2030 bonds have significantly lower modified durations (18 and 20, respectively, compared to 33 for the Austria 2086 bond), buy-and-hold investors are not adequately compensated for taking on the extra duration risk with the 2086 bond. The risk-reward balance skews unfavorably, making the 2086 bond unattractive.

3. Lack of Appeal for High-Conviction Investors:

For investors betting on a recession and an aggressive rate-cutting cycle, the Austria 2120 bond (ISIN: AT0000A2HLC4) is a more attractive option, offering a modified duration of 50. This makes it highly sensitive to interest rate fluctuations, providing higher  duration exposure. Compared to the 2086 bond, the 2120 bond is better suited for those seeking to maximize gains from falling interest rates.

4. Uncertainty Surrounding a Soft Landing Scenario:

The prospect of a soft landing, where central banks gradually reduce interest rates, doesn’t necessarily support a bullish outlook for ultra-long duration bonds. In such a scenario, the ultimate neutral rate remains uncertain. Bond futures markets expect the ECB to cut rates to 2.25% by March 2026. In this scenario, the 2.2% yield on the Austria 2120 bond could seem overvalued for two main reasons: first, it may not provide enough compensation for the duration risk; and second, as the ECB lowers rates, the possibility of higher future nominal growth could cause a bear steepening of the yield curve. This would drive the yield of the century bond higher relative to short-term yields, reducing its attractiveness to investors.

Austria’s Failed 2086 Bond Sale Signals Potential Trouble for Ultra-Long Bonds Like Austria 2120 and France 2072

The market's reaction to Austria's unsuccessful attempt to reopen its 2086 bond sale could have significant implications for other ultra-long duration issuances, such as the Austria 2120 bond and the France 2072 bond (FR0014001NN8). Here's what it might imply:

1. Reduced Appetite for Ultra-Long Duration Bonds:

The weak demand for the Austria 2086 bond suggests that investors are currently hesitant to extend duration, even with the prospect of a favorable interest rate environment. This sentiment could extend to other ultra-long bonds like the Austria 2120 and France 2072 bonds, leading to reduced demand for these instruments as well.

2. Increased Scrutiny on Yield Compensation:

Investors are likely to scrutinize the yield offered by ultra-long bonds more closely. If the yields on bonds like Austria 2120 and France 2072 do not sufficiently compensate for the substantial duration risk, they might struggle to attract interest. Given that the Austria 2120 bond's yield is close to expected future benchmark rates, investors may perceive it as overvalued, which could dampen demand further.

3. Preference for Shorter or Medium-Term Bonds:

As seen with Austria's 2086 bond, investors might prefer shorter or medium-term bonds that offer better compensation relative to their duration risk. This could lead to a shift in investor preference towards bonds with maturities in the 10-30 year range, where the yield curve might offer a more attractive better risk-adjusted returns.

4. Greater Focus on Liquidity and Market Timing:

The failure of the Austria 2086 bond sale could signal a shift in investor sentiment, making them more cautious about the liquidity of ultra-long bonds. While liquidity in the secondary market for these bonds is currently good, the lack of appetite in the primary market should not go unnoticed. This could be a warning sign of potential weakening demand in secondary markets as well, prompting investors to hold off on ultra-long issuances until more favorable conditions emerge.