Stripping Treasuries Up Most Since 2011 as Real Yields Gain
Demand for the Treasury securities most vulnerable to inflation is climbing to an almost two-year high as pension funds and insurance companies snap up discounted debt with consumer prices rising at the slowest since 2010.
Investment banks have increased Treasury Strips -- zero-coupon securities created by separating the interest and principal payments of a bond and selling them at a fraction of their face value -- by 4.8 percent to $203.2 billion from December through May, Treasury Department data show. The outstanding amount had dropped to as low as $171.7 billion in November 2009 from as high as $231.5 billion in April 1996.
While the Bloomberg U.S. Treasury Bond Index lost 1.9 percent (BUSY) since April on speculation the Federal Reserve could disclose plans to slow debt purchases as soon as at this week, consumer prices are increasing at the slowest pace since November 2010. Pensions and insurers, which need the longest-term investments to match payments for retirees and death benefits, are locking in the highest inflation-adjusted yields in 26 months, according to data compiled by Bloomberg.
“With inflation pretty much under control, real returns on Strips are offering better value than they have in quite a while,” Frank Salem, the head of liability-driven investing in New York at Columbia Management Investment Advisers, which oversees $341 billion and has been buying zero-coupon bonds for pension funds and insurers, said in a telephone interview June 11. “Investors still need yield.”
U.S. public pension funds alone are facing a $1.38 trillion funding gap for promises to retirees, according to the Pew Center on the States, the Washington-based nonpartisan group that studies and develops policy solutions.
Principal strips maturing in May 2042, the longest U.S. zero-coupon bond, traded at a price of $36.11 per $1,000 face value on June 14, to yield 3.56 percent. The bonds, which pay a lump sum equal to the initial investment plus the imputed interest at maturity, offer a real yield of 2.49 percent once the 1.1 percent annual rate of inflation is taken into account.
Real returns on 30-year Strips were as low as 1.35 percent on March 1 amid concern $85 billion in federal spending cuts scheduled to go into effect would slow economic growth.
“It’s an economically attractive yield environment relative to recent history,” Kelly Cliff, the chief investment officer of public markets at Callan Associates in San Francisco, which advises institutions with assets totaling $1.8 trillion, said in a June 12 phone interview. “Strips are more attractive.”
Buying 30-year Strips, which have lost 9.1 percent this year according to a Bank of America Merrill Lynch index, is the biggest bet bond investors can make that inflation, which erodes the value of fixed returns, will remain low.
Losses have been greater than on 30-year Treasuries, which have declined 5.6 percent, because bonds pay interest every six months, while Strips make single payments upon maturity, making them riskier as interest rates climb.
The bond market is showing the lowest inflation expectations in a year. The difference between yields on 30-year bonds and debt indexed for changes in the consumer price index, known as the break-even rate that projects the annual inflation rate over the life of the securities, dropped to 2.11 percent on June 13 from as high as 2.69 percent in September. It was at 2.15 percent today.
Inflation is declining even as the economy expands. Gross domestic product will increase 1.9 percent this year and 2.7 percent in 2014, according to median estimates of economists surveyed by Bloomberg News. The last time yields rose while inflation slowed was four ago, following President Barack Obama’s $787 billion stimulus plan. Yields later fell.
Even so, yields on benchmark 10-year notes climbed to a 14-month high of 2.29 percent on June 11 on concern the Fed could taper its $85 billion in monthly purchases of mortgage bonds and Treasuries if the economy exhibits sustained improvement.
The 10-year note rose last week, with the yield falling four basis points to 2.13 percent, according to Bloomberg Bond Trader prices, the first weekly drop in yields since the period ended April 26. The yield fell two basis points to 2.11 percent as of 8:15 a.m. in New York.
Yields have risen from 1.76 percent at the start of the year, though they’re still below 4.83 percent average for 10-year securities over the past two decades.
“Even though rates have risen some, they are still extremely low, and there isn’t enough yield in Strips to compensate for the risk of much higher rates,” said Rich Sega, the chief investment officer for Hartford, Connecticut-based Conning Inc., which manages almost $87 billion for insurance companies. “The long-run trend is for the economy to bump up with positive growth, which will eventually mean inflation and higher rates.”
Unemployment in the U.S. rose to 7.6 percent in May as the economy created 175,000 jobs, more than the forecast of 163,000 in a Bloomberg survey. While the jobless rate is down from 7.9 percent in October, it’s above the Fed’s goal of 6.5 percent before the central bank would consider raising its target rate for overnight loans between banks from the record-low zero to 0.25 percent it has maintained since December 2008.
Fed officials meeting June 18-19 in Washington may weigh how much changes in inflation and the labor market will influence the pace of monthly asset purchases.
Policy makers led by Chairman Ben S. Bernanke will trim bond purchases 24 percent to $65 billion a month at the Oct. 29-30 meeting of the Federal Open Market Committee, according to the median estimate in a survey of 59 economists.
An investor buying $10 million of the current 30-year Strip now would gain about 0.07 percent if 30-year bond yields end the year at 3.4 percent, as forecast by economists surveyed by Bloomberg. That compares to a projected 0.007 percent loss for 30-year bonds, according to Bloomberg calculations.
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 Fed Chairman Paul Volcker raised rates as high as 20 percent.
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.
“At these higher rate levels, Strips give a lot of bang for your buck,” Sean Kurian, a portfolio manager at JPMorgan Asset management in Columbus, Ohio, who is advising insurance companies and pension funds to buy zero-coupon bonds, said in a telephone interview June 14. “There is still a lot of money looking to get in.”
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