Pensions Rush to Buy Treasury Strips?

Joe Rennison of the Financial Times reports, Pension fund demand drives rise in Treasury ‘strips’ activity:

Pension fund demand for longer-dated US government bonds has sparked a sharp rise in Treasury “strips” activity ahead of a tax break ending this month.

With a new 21 per cent rate set to replace the old 35 per cent level later this month, pension plans have been rushing to buy strips, whereby existing 30-year Treasury bonds are separated into two types of security: one that only pays a fixed rate of interest, or coupon, over a set period, and another that is sold at a steep discount as it pays out only its principal value upon maturity.

Ahead of the tax break expiring on September 15, US companies have been racing to invest more cash in the bond market to help fund their pension liabilities.

Principal payments, also known as zero-coupon bonds, are particularly attractive for pension funds because their price is more sensitive to interest rates over time. That means owning a zero-coupon bond can help a pension fund match more closely their future payments for retirees.

But pension funds have also sought interest-only payments because they also help them match liabilities over the coming decades.

William O’Donnell, strategist at Citi, said pension funds are looking to hedge their long-term liabilities across interest rate products, and are therefore seeking both zero-coupon and interest-only strips alongside buying long-dated Treasury futures contracts and total return swaps, derivatives tied to underlying assets.

The outstanding value of stripped Treasury bonds has risen $28.7bn this year to $278.6bn, already exceeding 2017’s full-year increase of $25.1bn, according to data from the US Treasury.

It comes as the 30-year Treasury yield has risen around 26 basis points since the start of the year, dropping from a peak of 3.25 per cent in mid-May to about 3 per cent.

Market expectations of inflation over the coming three decades remain in a range capped at 2.20 per cent, with the Federal Reserve’s tightening of short-term interest rates helping to contain prices.

The price of zero-coupon strips has fallen more than 5 per cent this year, according to an index compiled by Intercontinental Exchange and Bank of America Merrill Lynch.

Stripping of Treasury bonds had already picked up over the past couple of years. Companies have been keen to top up pensions as rising bond yields and soaring stock prices have helped reduce their pension fund deficits.

“It’s part of the broader trend of pension funds de-risking and buying more long bonds to hedge liabilities, which is accelerated by more contributions being made ahead of the tax deadline,” said Matt McDaniel, who leads pension fund consultancy Mercer’s US financial strategy group.

The head of Treasury trading at one large US bank said they have seen record appetite from pension funds buying principal strips, but they expect it to slow after the tax deadline has passed.

Such a slowdown could push longer-dated interest rates higher after a substantial drop this year. However, others expect demand to continue. “We do not believe that the demand for longer-dated fixed-income will fall off a cliff,” said Mr O’Donnell.

I highly doubt demand for longer-dated fixed income will fall off a cliff after the tax deadline has passed as pensions will continue hedging their long-dated liabilities as best as possible.

More importantly, as I explained in July, take all this talk of US corporations driving the rally in Treasurys with a grain of salt:

What's going on? Well, I've told you, the global economy is slowing and that's the number one factor driving US long bond yields lower (prices higher) and it's no surprise that the recent rally in US Treasurys coincides with the selloff in emerging market stocks (EEM):

How low can emerging market shares go? They can go much lower, especially if a full-blown trade war breaks out and the US dollar (UUP) keeps soaring:

Will we get a crisis this summer or this fall? Maybe or maybe not, it's too early to tell.

This comment was to warn investors to ignore a lot of nonsense in the media about corporations driving Treasury yields lower and once the tax advantage evaporates, yields are headed higher. At the margin, their contributions help, but there is something else going on here, something much bigger and potentially more sinister.

Fast forward to today. Emerging market stocks (EEM) are in a bear market and might head even lower and the US dollar (UUP) continues to creep up (click on images):

My point is this, it's what happens outside the United States which matters more in terms of inflation expectations and the demand for Treasuries. At the margin, corporations rushing to buy "strips" ahead of the tax deadline helps but that's not the primary driver of US long bond yields.

Below, Ruchir Sharma of Morgan Stanley Investment Management thinks we are close to a once-in-a-lifetime buying opportunity for emerging markets but Clive McDonnell from Standard Chartered Bank says emerging market countries face a lot of structural problems.

All I know is if we see a full-blown emerging markets crisis this fall, you will see inflation expectations sink, the US dollar will soar higher and Treasury yields will plummet to new lows.

So far, we are not at crisis levels but these markets are edgy, weakness in stocks this week underscores this nervousness but emerging markets could bounce from these levels so don't throw in the towel just yet.