Zero-coupons bonds No.1 with investors

The U.S. government debt most vulnerable to inflation is generating the best returns as the economic recovery slows and the rally in commodities cools. Demand for zero-coupon bonds is rising so fast that Wall Street banks created $205.2 billion of them as of May, the most in three years and just $3.6 billion away from levels last seen at the beginning of 2000, according to the Treasury Department. So-called Strips maturing in 30 years have returned 9.5 percent this quarter, compared with 6.6 percent for the benchmark bond due in 2041, Bank of America Merrill Lynch index data show. Bonds lost money in the first quarter of the year as the 15 percent increase in oil prices and the Federal Reserve's efforts to pump money into the financial system by purchasing $600 billion of Treasuries raised expectations for faster inflation. Those worries dissipated as reports showed rising unemployment, a slowdown in manufacturing, a drop in home sales and lower consumer confidence. Strips are “where you make the most money,” said Van Hoisington, president in Austin, Texas of Hoisington Investment Management Co., which oversees about $5 billion, almost half of which is invested in the debt. “We have been in the camp that economic activity would be very sluggish. So far that seems to be on point.” Bonds are pricing in 2.17 percent inflation in the next decade, compared with an average rise in the consumer price index of 2.5 percent since 2000, based on the spread between yields on 10-year government notes and Treasury Inflation- Protected Securities. The difference, known as the break-even rate, peaked this year of 2.66 percent on April 11. ‘Very Severely' “The markets are reacting very, very severely to weakening economic data,” said Ray Humphrey, a senior money manager for TIPS, government and non-dollar debt at Hartford Investment Management, which oversees about $160 billion in Hartford, Connecticut. “You buy the cheapest and most sensitive part of the U.S. bond curve, and that would be your 30-year Strips.” Yields on 10-year Treasuries fell to 2.92 percent on June 9, the lowest since December 2010, from 3.77 percent on Feb. 9, the 2011 high. The rate on the 3.125 percent security maturing in May 2021 was little changed at 2.98 percent as of 9:55 a.m. in London, according to Bloomberg Bond Trader prices. Signs of a slowing expansion caused yields on Treasuries of all maturities to fall to an average of 1.59 percent on June 8, the lowest level since November, from 2.19 percent on Feb. 8, Bank of America Merrill Lynch indexes show. Forecasts Cut Barclays Capital Inc. cut its forecast for second-quarter economic growth on June 3 to a 2 percent annual rate from 3.5 percent. The U.S. jobless rate climbed to 9.1 percent last month. Home prices in 20 U.S. cities dropped in March to the lowest level since 2003, figures from the S&P/Case-Shiller index showed on May 31. The amount of zero-coupon bonds created by Wall Street firms has climbed from $171.7 billion in November 2009, which was the least since February 2003. Strips lost 17 percent in the fourth quarter of 2010 as inflation concerns mounted and the Standard & Poor's GSCI index of 24 commodities rallied 15.7 percent, the best three-month return since the second-quarter of 2009. Treasuries lost 2.7 percent and U.S. corporate bonds declined 0.57 percent. Banks also made fewer Strips because concerns about inflation increased as the Fed's quantitative-easing programs and record borrowing by the administration of President Barack Obama pumped an unprecedented $2.3 trillion in cash into the economy. Best and Worst Zero-coupon securities due in 30 years had their best and worst months in more than two decades during the last recession. The debt returned 26.7 percent in December 2008, a month after the consumer price index plunged 1.8 percent, the biggest drop in history, according to Bank of America Merrill Lynch index data. A month later, the securities lost 24 percent. Returns for Strips due in 30 years of 5.3 percent in May top the 1.6 percent for Treasuries overall and 1.21 percent for corporate bonds, the data show. Treasuries don't pay enough for Pacific Investment Management Co.'s Bill Gross, who reiterated on June 3 that mortgages, corporate bonds and sovereign debt of other nations are more attractive than U.S. government securities for his $243 billion Total Return Fund. Rates are too low once inflation is taken into consideration, with bonds due in 10 years and less yielding under the 3.2 percent increase in the consumer price index in the 12 months ended April 30. Higher Rates While returns on Pimco's flagship fund are lagging behind peers this year, Gross has a history of rebounding. In 2007, the Total Return Fund trailed the performance of 80 percent of comparable funds through June before rebounding to beat 99 percent of them for the year as the Fed began to lower interest rates, as he predicted, according to data compiled by Bloomberg. “Rates will be rising,” said Rob Crimmins, a fixed-income manager in New York at RS Investments, which oversees $30 billion. “This latest month of weaker-than-expected economic data is transitory. The economy will pick up in the second half of the year.” Strips were conceived by Salomon Brothers Inc. and Merrill Lynch & Co. in the 1980s after then-Fed Chairman Paul Volcker broke the back of inflation that reached a 14.8 percent annual rate in March 1980 by raising interest rates as high as 20 percent, even as the economy slipped into the longest post-World War II recession. By the time he stepped down from the central bank in 1987, inflation slowed to 4.3 percent. Inflation Tame Strips -- short for separate trading of registered interest and principal of securities -- are created by breaking up the interest and principal payments of a debenture and selling them at a discount. The consumer price index is forecast to rise 0.1 percent in May from the previous month when the Labor Department reports the data on June 15, according to the median estimate of 60 economists surveyed by Bloomberg News. The gauge increased 0.4 percent in April, matching the survey forecast and following a 0.5 percent advance in March, figures showed May 13. The S&P GSCI index of commodities has fallen 7.9 percent from the high this year on April 8. Crude oil futures have declined 13 percent from the peak of $114.4 a barrel on April 29. ‘Coming Down' “Inflation expectations definitely have been coming down,” said Amit Agrawal, a senior manager of government and inflation-linked bonds in New York at PineBridge Investments, which oversees $81 billion. “People believe the Fed isn't going to raise rates this year and QE2 is going to end,” he said in reference to the Fed's second round of asset purchases, known as quantitative easing. The central bank's $600 billion in purchases of Treasuries are due to end this month. While Fed Chairman Ben S. Bernanke said in the June 7 speech that record monetary stimulus is still needed to boost an “uneven” and “frustratingly slow” economic recovery, he gave no indication the Fed will start a third round of QE. “On the margin, you don't have the stimulus on the economy,” said Thanos Bardas, a managing director at Chicago- based Neuberger Berman LLC, which oversees about $85 billion in fixed-income assets. “Rates should go down, not up.” Longer-maturity Strips are becoming more desirable as investors push back their estimates for when the Fed will begin raising interest rates to 2012. A rate increase of 1 basis point would cause a 30-year Strip with a par value of $1,000 to fall 29.3 basis points, or $2.93 per $1,000 face amount. A Treasury with the same maturity would decline $1.67. “Zeros are relatively cheap,” Hoisington said. “If you're bullish on risk coming down, if you think the long end is going to do better, then zeros are unusually attractive.” --Bloomberg News--