The US 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 per cent this quarter, compared with 6.6 per cent 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 per cent 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 2.18 per cent inflation in the next decade, compared with an average rise in the consumer price index of 2.5 per cent 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 per cent 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 per cent on June 9, the lowest since December 2010, from 3.77 per cent on Feb. 9, the 2011 high. The yield on the 3.125 per cent security maturing in May 2021 rose 4 basis points to 3.01 per cent as of 8:27 a.m. in New York.