Friday, March 28, 2014

Liquidity Preference and Solidity Preference in the 19th Century

So I've been reading Homer and Sylla's History of Interest Rates. One of the many fascinating things I've learned, is that in the market for federal debt, what we today call an inverted yield curve was at one time the norm.

From the book:
Three small loans floated in 1820–1821, principally to permit the continued redemption of high rate war loans, provide an interesting clue to investor preference... These were: 
$4.7 million “5s of 1820,” redeemable in 1832; sold at 100 = 5%.
“6s of 1820,” redeemable at pleasure of United States; sold at 102 = 5.88%.
“5s of 1821,” redeemable in 1835; sold at 1051⁄8 =4.50%, and at 108 = 4.25%. 
The yield was highest for the issue with early redemption risk and much lower for those with later redemption risks.
Nineteenth century government bonds were a bit different from modern bonds, in that the principal was repaid at the option of the borrower; repayment is usually not permitted until a certain date. [1] They were also sold with a fixed yield in terms of face value -- that's what the "5" and "6" refer to -- but the actual yield depended on the discount or premium they were sold at. The important thing for our purposes is that the further away the earliest possible date of repayment is, the lower the interest rate -- the opposite of the modern term premium. That's what the passage above is saying.

The pattern isn't limited to the 1820-21 bonds, either; it seems to exist through most of the 19th century, at least for the US. It's the same with the massive borrowing during the Civil War:
In 1864, although the war was approaching its end, it had only been half financed. The Treasury was able to sell a large volume of bonds, but not at such favorable terms as the market price of its seasoned issues might suggest. Early in the year another $100 million of the 5–20s [bonds with a minimum maturity of 5 years and a maximum of 20] were sold and then a new longer issue was sold as follows: 
1864—$75 million “6s”  redeemable in 1881, tax-exempt; sold at 104.45 = 5.60%. 
The Treasury soon made an attempt to sell 5s, which met with a lukewarm reception. In order to attract investors to the lower rate the Treasury extended the term to redemption from five to ten years and the maturity from twenty to forty years
1864—$73 million “5%, 10–40s of 1864,” redeemable 1874, due in 1904, tax-exempt; sold at 100 = 5%.
Isn't that striking? The Treasury couldn't get investors to buy its shorter bonds at an acceptable rate, so they had to issue longer bonds instead. You wouldn't see that story today.

The same pattern continues through the 1870s, with the new loans issue to refinance the Civil War debt. The first issue of bonds, redeemable in five to ten years sold at an interest rate of 5%; the next issue, redeemable in 13-15 years sold at 4.5%; and the last issue, redeemable in 27-29 years, sold at 4%. And it doesn’t seem like this is about expectations of a change in rates, like with a modern inverted yield curve. Investors simply were more worried about being stuck with uninvestable cash than about being stuck with unsaleable securities. This is a case where “solidity preference” dominates liquidity preference.

One possible way of explaining this in terms of Axel Leijonhufvud's explanation of the yield curve.

The conventional story for why long loans normally have higher interest rates than short ones is that longer loans impose greater risks on lenders. They may not be able to convert the loan to cash if they need to make some payment before it matures, and they may suffer a capital loss if interest rates change during the life of the loan. But this can't be the whole story, because short loans create the symmetric risk of not knowing what alternative asset will be available when the loan matures. In the one case, the lender risks a capital loss, but in the other case they risk getting a lower income. Why is "capital uncertainty" a greater concern than "income uncertainty"?

The answer, Leijonhufvud suggests, lies in
Keynes' ... "Vision" of a world in which currently active households must, directly or indirectly, hold their net worth in the form of titles to streams that run beyond their consumption horizon. The duration of the relevant consumption plan is limited by the sad fact that "in the Long Run, we are all dead." But the great bulk of the "Fixed Capital of the modem world" is very long- term in nature and is thus destined to survive the generation which now owns it. This is the basis for the wealth effect of changes in asset values. 
The interesting point about this interpretation of the wealth effect is that it also provides a price-theoretical basis for Keynes' Liquidity Preference theory. ... Keynes' (as well as Hicks') statement of this hypothesis has been repeatedly criticized for not providing any rationale for the presumption that the system as a whole wants to shed "capital uncertainty" rather than "income uncertainty." But Keynes' mortal consumers cannot hold land, buildings, corporate equities, British consols, or other permanent income sources "to maturity." When the representative, risk-averting transactor is nonetheless induced by the productivity of roundabout processes to invest his savings in such income sources, he must be resigned to suffer capital uncertainty. Forward markets will therefore generally show what Hicks called a "constitutional weakness" on the demand side.
I would prefer not to express this in terms of households' consumption plans. And I would emphasize that the problem with wealth in the form of long-lived production processes is not just that it produces income far into the future, but that wealth in this form is always in danger of losing its character as money. Once capital is embodied in a particular production process and the organization that carries it out, it tends to evolve into the means of carrying out that organization's intrinsic purposes, instead of the capital's own self-expansion. But for this purpose, the difference doesn't matter; either way, the problem only arises once you have, as Leijonhufvud puts it, "a system 'tempted' by the profitability of long processes to carry an asset stock which turns over more slowly than [wealth owners] would otherwise want."

The temptation of long-lived production processes is inescapable in modern economies, and explains the constant search for liquidity. But in the pre-industrial United States? I don't think so. Long-lived means of production were much less important, and to the extent they did exist, they weren't an outlet for money-capital. Capital's role in production was to finance stocks of raw materials, goods in process and inventories. There was no such thing, I don't think, as investment by capitalists in long-lived capital goods. And even land -- the long-lived asset in most settings -- was not really an option, since it was abundant. The early United States is something like Samuelson's consumption-loan world, where there is no good way to convert command over current goods into future production. [2] So there is excess demand rather than excess supply for long-lasting sources of income.

The switch over to positive term premiums comes early in the 20th century. By the 1920s, short-term loans in the New York market consistently have lower rates than corporate bonds, and 3-month Treasury bills have rates below longer bonds. Of course the organization of financial markets changed quite a lot in this period too, so one wouldn't want to read too much into this timing. But it is at least consistent with the Leijonhufvud story. Liquidity preference becomes dominant in financial markets only once there has been a decisive shift toward industrial production by long-lived firm using capital-intensive techniques, and once claims on those firms has become a viable outlet for money-capital.


* * *


A few other interesting points about 19th century US interest rates. First, they were remarkably stable, at least before the 1870s. (This fits with the historical material on interest rates that Merijn Knibbe has been presenting in his excellent posts at Real World Economics Review.)



Second, there's no sign of a Fisher equation. Nominal interest rates do not respond to changes in the price level, at all. Homer and Sylla mention that in earlier editions of the book, which dealt less with the 20th century, the concept of a "real" interest rate was not even mentioned.


As you can see from this graph, none of the major inflations or deflations between 1850 and 1960 had any effect on nominal interest rates. The idea that there is a fundamentals-determined "real" interest rate while the nominal rate adjusts in response to changes in the price level, clearly has no relevance outside the past 50 years. (Whether it describes the experience of the past 50 years either is a question for another time.)

Finally, there is no sign of "crowding out" of private by public borrowing. It is true that the federal government did have to pay somewhat higher rates during the periods of heavy borrowing (and of course also political uncertainty) in the War of 1812 and the Civil War. But rates for other borrowers didn't budge. And on the other hand, the surpluses that resulted in the redemption of the entire debt in the 1830s didn't deliver lower rates for other borrowers. Homer and Sylla:
Boston yields were about the same in 1835, when the federal debt was wiped out, as they were in 1830; this reinforces the view that there was little change in going rates of long-term interest during this five- year period of debt redemption.
If government borrowing really raises rates for private borrowers, you ought to see it here, given the absence of a central bank for most of this period and the enormous scale of federal borrowing during the Civil War. But you don't.



[1] It seems that most, though not all, bonds were repaid at the earliest possible redemption date, so it is reasonably similar to the maturity of a modern bond.

[2] Slaves are the big exception. So the obvious test for the argument I am making here would be to find the modern pattern of term premiums in the South. Unfortunately, Homer and Sylla aren't any help on this -- it seems the only local bond markets in this period were in New England.

39 comments:

  1. The stability of nominal interest rates could be put down to expectations; since people expected price stabilty, the long-term expected inflation rate is zero. They tended to do things like return to pre-war gold parities.

    The inversion could be interpreted as long-term bonds being less risky for income generating purposes. You know what rate you are locking in. Whereas with rolling short-term debt, you could run into the present situation - short rates being stuck below your target rate of return.

    I am not sure when the US railway boom started, but railways were mainly bond-financed.

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    1. Mostly agree. However, while it is true that most people pre WWII expected prices to be stable in the long run, I don't think that explains stability of nominal rates. After all, if you expect long-run stability of price level, and if current level is 25 percent above or below the historical norm (not uncommon), you should expect substantial inflation/deflation going forward. The way expectations come into this, I think, is simply that people expected interest rates themselves to be stable. If everyone thinks that the long (nominal) rate is normally around 5-6 percent and that any deviations are likely to be short-lived, then almost nobody is going to agree to a long loan at a rate much different from this, regardless of inflation expectations.

      The inversion could be interpreted as long-term bonds being less risky for income generating purposes.

      Right. But the question becomes, why are asset owners more worried about income risk in the 19th century, and capital risk in the 20th century?

      I am not sure when the US railway boom started, but railways were mainly bond-financed.

      Yes, railways were the first industries to externally finance capital investment on a large scale. There was a very large market in railway bonds from the 1870s; until the 1890s merger wave it was the only significant market for long-maturity private securities, and railways were by far the most important form of long-lived capital asset.

      I agree that the development of railways should in principle have shifted the balance toward capital uncertainty, and that this poses a challenge for the argument I' suggesting here.

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    2. Good point on the price level divergence. But if you are looking at a consol, even a 25% divergence in the price level may not move the expectations that much relative to other factors.

      As for the riskiness, it could be interpreted as a question of a longer horizon. If your investment horizon is 5 years, and you have self-reinforcing mean reversion in long-term rates, a consol may have less return risk than rolling TBills. This is an alternative way of phrasing income risk, but it fits within a more modern risk/return analysis framework.

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    3. JW Mason, "But the question becomes, why are asset owners more worried about income risk in the 19th century, and capital risk in the 20th century?"

      Is it possible that trading costs are much less significant nowadays so that nowadays people don't see so much distinction between drawing down capital to substitute for income so income stability is no longer at such a premium? Nowadays long run inflation (rather than the alternate inflation-deflation cycle of the 1800s) anyway makes income stability a bit of a mute point today. Perhaps also today the price of bonds gets set by people holding them with high leverage. If you just aim to hold a consol bond for decades and live off the income, you don't care if the bond price gyrates around but if you want to hold it at constant 5x leverage or whatever, then price gyrations cause margin calls and volatility decay etc.

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  2. Re: the slave exception. I'm no expert in 19th century finance, BUT I really wonder if there isn't something to be found in the records of long-lived I-banks that would have been close to the slave trade: Lazard, Lehman, and Alex Brown all come to mind. And to get a little hokey, I'd also look at insurance contracts related to slaves.

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    1. What I would want to know is, did bond purchasers in slave-owning states show the same preference for longer-maturity bonds? I imagine it's possible to answer this question, but not on the basis of the data used by Homer and Sylla. Municipal bonds in the pre-Civil War US seem to have been limited to New England, and Confederate debt obviously poses a whole other set of problems.

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  3. "The switch over to positive term premiums comes early in the 20th century. By the 1920s, short-term loans in the New York market consistently have lower rates than corporate bonds, and 3-month Treasury bills have rates below longer bonds. Of course the organization of financial markets changed quite a lot in this period too..."

    Not to mention, creation of the Federal Reserve...

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    1. Yes. All kinds of things were changing in this period. The post suggests a level of confidence in my hypothesis that I really don't feel.

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  4. Is the phenomenon of short dated bonds being higher interest connected with those bonds not being risk free because the gold standard created a default risk? So the government bonds then were more like corporate bonds or eurozone bonds now. I think when BP got in trouble with the gulf oil spill, short term corporate debt yields for BP went sky high whilst long term yields were not so extreme. All BP debt had the risk of losing the principle; longer term debt had the mitigating attribute that if things did turn out well after all, a long lasting stream of coupons would be paid; so the yield curve was dramatically inverted. I think the same yield curve inversion phenomenon occurred with some PIIG eurozone government debt. eg
    http://soberlook.com/2011/11/inverted-italian-yield-curve-spells.html

    In the case of the US civil war, there was no gold standard BUT the bonds from the losing side would still have possibly been written off (eg as with Nazi era debt after WWII). So the same phenomenon of the debt not being risk free would have caused the inverted yield curve.

    As an aside, in the UK we have some perpetual gilts -some from as far back as the 1700s. They all have somewhat higher yields than the 50year and 55year gilts issued recently. That higher yield is partly attributable to the perpetual gilts having less liquidity but also partly because they are redeemable/callable. With a conventional 55year risk free bond, the holder is certain of making a killing in the advent of a deflationary depression. With a callable bond, that possibility is tempered somewhat.

    I guess one explanation for why long term risk free bonds typically have higher yield than short term risk free bonds is the stochastic market efficiency hypothesis
    http://arxiv.org/pdf/1101.4548.pdf
    -basically every asset price converges towards the price at which it is not profitable to borrow money to buy more of it. Long dated bonds have volatile prices because a given change in yield means a bigger change in price for a longer duration bond. More volatile asset prices mean that leverage holdings entail volatility decay losses. If a one year risk free bond had a 3% yield and financiers could borrow short term at 1% -then the bond yield would get pushed down. BUT if a 50year bond had a 3% yield, it might well not be possible to profit from borrowing money at 1% to hold it. Someone who tried to maintain a position with the maximum say 20x leverage would need to be constantly selling off the bond in order to meet margin calls whenever the bond price fell. The volatility decay losses would consume any benefit from the differential between the yield of the long dated bond and the low interest short term borrowing.

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  5. Going along with my last comment:

    This is a link about the inverted yield curve for BP corporate debt after the gulf oil spill:
    http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/7822679/BP-oil-spill-Tony-Hayward-warns-top-BP-investors-its-likely-to-suspend-dividend.html
    "Yield curve inversions are one of the most obvious market signals that a borrower is expected to default, or even go bankrupt.
    The yield curves of US investment banks Bear Stearns and Lehman Brothers both inverted in the weeks and days leading up to their collapse"

    This link has an equation: http://www.hussmanfunds.com/wmc/wmc110620.htm
    " The implied probability of default is calculated as (1-exp(-(Y-Yf)*T))/(1-R), where Y is the yield in decimal form, Yf is the yield on a presumably default-free security (in this case, we're using comparable German yields), T is maturity, and R is the recovery rate, also in decimal form."

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    1. Stone-

      I'll have to think about this more. Part of the issue is the CDS market, which obviously doesn't apply in the 19th century. Another part is the idea that a troubled debtor might remain current on interest payments but miss near-term principal repayments. But that doesn't apply to the bonds we're talking about here, because repayment of principal is at the option of the debtor anyway, and early repayment of principal is precisely what the creditors want to avoid.

      So my preliminary view is that default fear is not what's going on here. But I admit I don't understand all this as well as I would like to.

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    2. Thinking more about this after I put that comment up, I started to think it was more to do with the alternate inflation/deflation pattern that happened in those days. I think that also fits in with the comments you made below (if I understood those right). I'm certainly also struggling with understanding all of this!

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    3. Corporate bond yield curves invert when there is a risk of default because all of the bonds move to the same dollar price. This is because they all pay off the same percentage of principal if they are in the same level of the corporate structure.

      If the prices of all the bonds drops to $80, the yields on short-dated bonds are much higher.

      However, this will not really apply in the case discussed here.

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    4. Brian-

      Thanks. That makes sense.

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  6. You say "no sign of a Fisher equation," but it's not at all clear what the sign would look like if there were one. It's plausible that, under a commodity standard, the price level is expected to mean-revert, and real interest rates are reflected mostly in (ex ante) temporary changes in the price level with fairly stable nominal interest rates. For example, if people's time preference becomes stronger, what do they do? They start buying more stuff and bidding up the price level in the short run, expecting it to fall again in the long run. Or, in Fisherian terms, they bid up the real interest rate, but not necessarily by bidding up the nominal interest rate. Empirically, without data about price expectations it's hard to say whether the Fisher equation applies or not.

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    1. Leaving aside the plausibility of this story, I don't think it works just as a matter of logic. Think about the the conventional story where the interest rate equilibrates people's time preference and the technical possibilities of converting present to future consumption -- the forces of Thrift and Productivity as they used to say. In that world, a shift in preferences toward present consumption should imply a higher real interest rate. But if the nominal interest rate is fixed, an increase in inflation due to higher demand for current consumption implies a lower real rate, not higher.

      Or maybe you are suggesting the sort of story behind the Dornbusch model of exchange rate adjustment, where an increase in the rate of time preference leads to an instantaneous jump in the price level, followed, for some reason, by a steady deflation back to the old price level? I'm sorry, but I don't understand how that's suppose to work. in the Dornbusch model, there is PPP to ensure that real exchange rates are mean-reverting. What's the mechanism in your story?

      Do you really believe this?

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    2. So, it just so happens that the fundamentals imply negative real rates just during major wars? If you are seriously proposing this story, I'm willing to engage it, but ... really?

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    3. Sorry if I'm in a muddle and this is all over my head but my impression of 1800s inflation history was that there were periods of inflation when the government was borrowing a lot to fund wars or whatever and the gold standard was let go BUT the general expectation was that those would always be swiftly followed by a severe deflation (after the gold standard was reimposed) that would reverse much of the inflation that had just happened. So buying a long term bond during a war time financial expansion when inflation was running at say +10% made a lot of sense even at a nominal yield of +4% because a period of -5% inflation (ie deflation) was a reasonable expectation.

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    4. This suggests a regular relationship between interest rates and the price level that just does not exist. Plot the nominal interest rate against average inflation over the next 5 or 10 or 20 years, you will never see anything like a slope of -1. Mostly you'll see a positive slope. Either essentially all inflation was unanticipated by bondholders, or bond yields were not set in this way.

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    5. Is it possible that in the 1800s, inflation was always unanticipated but deflation was presumed to be around the corner at times when bonds were being issued even if there was currently an inflation? So the yield curve was inverted because bond buyers were wanting an asset that would stretch out into a probable future period of deflation. Perhaps it wasn't even a case of future deflation being sure fire bet but rather of it being a fairly likely eventuality that it was as well to guard against by owning long bonds. Long bonds are the very best asset to have in a deflationary depression I guess -when dividends dry up from equities as companies suffer and tenant farmers fail to pay rents on farmland etc etc. I guess the second half of the 20th century made people forget about deflationary depressions as a phenomenon but at the end of 2008, prices of 30year US treasuries surged 30% on the hint that it could happen again.

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    6. Long *government* bonds are the best asset to have in a deflationary depression. Long *company* bonds tend to default. I wonder if this difference shows up in corporate bonds? I think it does, but I haven't rechecked the data recently.

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  7. It is difficult to assess your post because you have merely reported Homer and Sylla's claims without substantiating them; yet they are highly problematic. In no particular order, here are some of the problems:

    It is difficult to distinguish between real and nominal rates in the 19th century US because in that period money was convertible to specie; inflation and deflation were therefore at the mercy of shocks to ore discovery and mining technology and there is no particular reason why investors ought to have been able to predict inflation. In fact, the geometric mean of inflation between 1800 and 188 was -0.3% (as against -0.97% in Britain.) During this period, the average real return on long federal bonds was 5.71%, which is at variance with the claims you quote. America did not rid itself of its bimetallic proclivities until 1896 and redemption was in either gold or silver, at the option of the government; surely this had some effect on price.

    The federal debt as a fraction of GDP was very small, not only by today's standards but by contemporary standards compared to European countries. Banks were able to issue money against Federal bonds ("circulation privileges") which may have endowed long bonds with a liquidity *premium*, particularly since there were relatively few of them. During periods of stress, such as the civil war, the Federal government was obliged to issue short term debt to satisfy its funding requirements, which again is at variance with the long-term preference story. And if investors really preferred long debt so much, why didn't they just buy British consols? There was plenty of financial exchange between the US and Britain. For that matter, why didn't the US just issue its own consols?

    In short, I am skeptical of your premises.

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  8. Phil-

    Thanks for the informed comment. Let me see if I'm following you. When you write

    It is difficult to distinguish between real and nominal rates in the 19th century US

    you're referring to ex ante rates, correct? Distinguishing ex post real and nominal rates only requires a measurement of the price level, which presumably isn't dramatically more difficult for the 19th century US than for other times and places.

    there is no particular reason why investors ought to have been able to predict inflation

    So, even if 19th century interest rates show no signs of incorporating realized inflation, that is no reason to think they didn't incorporate expected inflation. I'm not saying that's wrong (or right), I just want to be clear if that's what you're saying.

    Banks were able to issue money against Federal bonds ("circulation privileges") which may have endowed long bonds with a liquidity *premium*, particularly since there were relatively few of them.

    May I offer a friendly amendment? A small float makes federal debt less liquid, not more. But it did enjoy a premium, because of demand from banks for treasuries as backing for their own notes issues. This definitely is one reason why treasury yields were generally low in the half-century before WWI. But I don't think it can explain the general pattern of inverted yield curves, which seems to apply to all kinds of debt, not just federal debt. it also doesn't explain the non-responsiveness of nominal yields to inflation.

    During periods of stress, such as the civil war, the Federal government was obliged to issue short term debt to satisfy its funding requirements

    I don't think this is correct. Do you have a reference?

    why didn't the US just issue its own consols?

    Because there was a deep-seated political idea that all federal debt should eventually be repaid.

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  9. JW Mason, for me this link illustrates just how valuable long term debt securities are in a deflation:
    http://www.jdawiseman.com/papers/finmkts/long-consultation.pdf

    The 1800s were a time when deflationary depressions were something that could reasonably be expected to be around the corner. Against that economic backdrop, is it any wonder that high quality long term debt securities were popular?

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  10. Isn't it also true that in the 1800s, current high inflation was predictive of a coming matching subsequent bout of deflation because long term there was no overall inflation. So a long term debt security would be sought after even at a currently negative real rate of interest as it could be safely assumed that it would span into a coming deflationary episode.

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  11. Stone, I appreciate your persistence but I'm not convinced. The fact is, bond yields in the 19th century are not predictive of future inflation. This may be because bondholders in that period did not think in terms of a "real" return (certainly no one wrote about it), or it may be because inflation was simply not predictable. But either way, "real" rates were not at all stable, either ex ante or ex post, while nominal rates were quite stable.

    In any case, none of this relevant to the inverted yield curve. If it is the "real" rate that is set by fundamentals, then inflation expectations should be incorporated into both short and long rates, so they won't affect the yield curve. To make this work, you are going to have to postulate steadily accelerating deflation.

    Why not instead throw out the idea of a "real" rate and also throw out the idea that credit markets are about the allocation of consumption over time. The stability of long rates was a monetary phenomenon -- maybe purely a convention, maybe something more institutional. Inflation expectations, to the extent they played a role at all, influenced the volume of credit by affecting demand for loans. And the inverted yield curve was due to a chronic shortage of secure, long-run investment opportunities. That's the more parsimonious story, to me.

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    1. JW Mason, I know you wrote that in the olden days, bonds were mostly redeemed at the earliest date so we should compare them to short term debt securities and not to callable long term debt securities. However if you were instead to view it as a comparison between callable and non callable bonds, then what you describe as a "persistent inverted yield curve" would actually just be like the yield premium that callable bonds have in modern times.

      From http://en.wikipedia.org/wiki/Callable_bond
      "Price of a callable bond is always lower than the price of a straight bond because the call option adds value to an issuer."

      Also check out: http://www.fanniemae.com/resources/file/debt/pdf/understanding-debt/Callable_Brochure.pdf
      Callable debt securities also offer investors the opportunity to potentially earn
      enhanced returns in exchange for taking call risk or selling convexity. Fannie Mae takes very seriously its role in being a flexible, responsive and efficient issuer of callable debt securities and providing investors adequate information to facilitate trading and investment of these securities. The company’s callable debt securities issued in the cash market have maturities ranging from one year to thirty years and call lockout periods ranging from three months to ten years or longer......In 2009 and 2010, Fannie Mae issued approximately $191.8 billion and $309.3 billion, respectively, of callable securities.

      It is interesting that in the UK back in those days, treasury bonds were NOT redeemed at the earliest date even though they were callable and those bonds are still around today and still today seem to have a slight yield premium because they are callable (the yield curve flattens off at about 30year then has a step up between the 55year conventional gilts and the callable undated ancient War loans and consols) though it is hard to know whether that it more to do with less liquidity for those small ancient bonds.

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    2. This is another link about modern savers valuing bonds that are not callable:
      http://www.cambridgeconnection.com/deflecting-deflation-doomsday/

      "There is another very significant advantage to U.S. Treasury Bonds: they are "non-callable." Corporate and municipal bonds have a provision that the issuer can pay off the bonds early and buy them back. So if interest rates drop, they just issue a new round of bonds at the lower rate and then pay off their outstanding bonds with higher rates. So if you buy a 20 year corporate bond with a 9% yield, you don't have a guarantee that you will get that rate for the whole 20 years. You can bet that if rates drop to 4-6% over the next 5 or 10 years, your bond will get called.
      In the late 70's many clients bought municipal bonds with yields of 14-20%; these have all been long since "called" and paid off. But those savvy clients who bought 30 year U.S. Treasury Bonds (these are called "long bonds"), with a 12% yield are still getting their 12% and will continue to get it for the full 30 years!"

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    3. JW Mason, this is a really interesting post of yours and I really want to understand. I've reread it several times and mulled it over and over!

      I think part of my difficulty stems from your idea, "Investors simply were more worried about being stuck with uninvestable cash than about being stuck with unsaleable securities."
      -Isn't it the case that investors "being stuck with uninvestible cash" should be the same thing as bond yields falling to lower yields? And yet you say that bond yields didn't ever fall enough to explain it. So was it a long running persistent fear that they probably would fall in the future but that fear was never realized? So if one person had bought a bond with a short term redemption date, and then, when it was redeemed, bought another bond and so on, then that person would have beaten the person who instead bought the long term bond? Basically it was a mis-pricing that came about because the bond market always had a lurking fear that rates would decrease.

      I suppose looking back over the last few decades there has been a similar dramatic mispricing. Someone who bought 30year treasuries at 15% yield or whatever in 1980 and then rolled those over until now keeping a constant long duration would have massively beaten someone who instead rolled over short term debt and conversely someone who bought 30year treasuries in 1946 and rolled them over until 1980 would have faced calamitous losses that would have been avoided by rolling over short term debt.

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    4. I suppose people in the 1820s might not have envisaged that the industrial revolution was going to be as transformative as it was. Perhaps the industrial revolution kept interest rates up at 4% when the bond market was presuming that they could fall way down. So the bond market was taken by surprise and with hindsight was shown to have overvalued long term debt throughout the 1800s?

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    1. Whenever I try to understand garble like this, I wonder if the mental processes one uses to try to understand it are that different from trying to understand, say, "The determinate social character of the means of production in capitalist production—expressing a particular production relation —has so grown together with, and in the mode of thought of bourgeois society is so inseparable from, the material existence of these means of production as means of production, that the same determinateness (categorical determinateness) is assumed even where the relation is in direct contradiction to it."
      Though I think you'd be hard-pressed to describe what the social character of the means of production are for payday text loan scammers.

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