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Treasury Strips Reach 14-Year High as Volatility Drops

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July 8 (Bloomberg) -- The outstanding amount of zero-coupon U.S. Treasury notes and bonds jumped to the highest level in more than 14 years as low yields and weak market volatility spurred demand from pension funds and insurance companies looking to match assets with liabilities.

Zero-coupon debt, or strips, short for separate trading of registered interest and principal securities, is created by Wall Street firms that split bonds into their face amount and individual coupon payments. The amount climbed to $214 billion in June, the most since October 1999, according to Treasury Department data released yesterday. The 2.3 percent jump was the biggest gain since February 2013.

Volatility and yields sank this year as turmoil in Ukraine and the Middle East stoked demand for safety, damping earlier speculation that yields would rise as investors sought riskier assets. Yields on 30-year bonds reached an almost one-year low of 3.26 percent on May 29. Bank of America Merrill Lynch’s MOVE Index, a gauge of expectations for swings in bond yields based on volatility in over-the-counter options on Treasuries due in two to 30 years, reached 52.7 percent on June 30, the lowest since May 2013.

“There has been a lot of demand from pension funds and insurance companies, who are capitulating after everyone expected rates to rise earlier this year,” said Aaron Kohli, an interest-rate strategist BNP Paribas SA in New York, one of 22 primary dealers that trade with the Federal Reserve. “We may see more demand, as the yield pickup has been attractive, and the threat of much higher rates has diminished since the start of the year.”

Strips Return

Treasury 30-year bond yields declined three basis points, or 0.03 percentage point, to 3.44 percent yesterday in New York, according to Bloomberg Bond Trader prices. They will rise to 4 percent by year-end, according to the median forecast in a Bloomberg survey of economists taken from June 6-11. At the start of the year, yields were projected to increase to 4.25 percent by Dec. 31.

Thirty-year strips returned 21 percent this year, compared with a gain of 11 percent by 30-year bonds, according to Bank of America Merrill Lynch index data.

The securities are considered the most vulnerable to inflation, which has persisted below the Fed’s 2 percent target rate.

Strips, conceived by Salomon Brothers Inc. and Merrill Lynch & Co., were first sold in 1985 as investors sought to lock in returns on 30-year bonds that yielded more than 15 percent, after surging consumer prices began to recede. Inflation reached a 14.8 percent annual rate in March 1980 before then then-Fed Chairman Paul Volcker raised rates as high as 20 percent.

Deferred Taxes

Zero-coupon securities have traditionally been most popular for investments on which taxes can be deferred, such as individual retirement accounts and pension plans, since any increase in value is accrued annually. The known cash value at specific future dates enables savers and investors to tailor their use.

The Fed’s preferred inflation gauge, which is tied to consumer spending, has fallen short of the target for 25 consecutive months, even as it has increased since February. The personal consumption expenditures deflator rose 1.8 percent in May from a year earlier, according to data released June 26.

To contact the reporter on this story: Cordell Eddings in New York at ceddings@bloomberg.net

To contact the editors responsible for this story: Dave Liedtka at dliedtka@bloomberg.net Greg Storey, Kenneth Pringle

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