Dangerous strips

By Felix Salmon
May 24, 2010
headline which strikes you first: "Strippers Declare Inflation Dead as Dealers Revive Zero-Coupon Treasuries". Ha, strippers. Geddit? But behind the headline is a very long and dry article about the market in long-dated zero-coupon Treasury bonds, which apparently are all the rage right now:

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It’s the headline which strikes you first: “Strippers Declare Inflation Dead as Dealers Revive Zero-Coupon Treasuries”. Ha, strippers. Geddit? But behind the headline is a very long and dry article about the market in long-dated zero-coupon Treasury bonds, which apparently are all the rage right now:

“We are in some sort of a new normal environment and inflation is not going to be a problem anytime soon,” said Jeffrey Caughron, an associate partner in Oklahoma City at Baker Group Ltd., which advises community banks investing $20 billion of assets and is recommending that some clients buy zero-coupon Treasuries. “Strips would be beneficial if we go to anything close to deflation.”

Treasury 30-year zero-coupon bonds have returned 16.7 percent this year, including 15.2 percent in May, according to Bank of America Merrill Lynch indexes.

Strips are outperforming the rest of the $7.9 trillion market for Treasuries…

They’re beating the Standard & Poor’s 500 Index, down 2.46 percent in 2010, and the Reuters/Jefferies CRB Index of 19 commodities, which has fallen 11.3 percent. Treasury Inflation- Protected Securities, or TIPS, developed in 1997, have also lagged behind, gaining 3.32 percent on average.

It’s true that strips are great buys in a deflationary environment, because they carry no reinvestment risk. But it’s also true that these things are highly volatile, and I would think very long and very hard before advising any small or even medium-sized community bank to play in this particular pool.

Here’s a graph of the yield on 30-year strips since the beginning of 2008. The 17% return this year, as you’ll see, is positively quiescent by Strips standards, and comes only in the wake of a torrid 2009, in which strips lost about half their value. As for 2008, well, the less said about that, the better:

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I’ve mentioned in the past that TIPS strips would be an interesting long-term investment, if they actually traded and existed, which they don’t. But long-dated Treasury bond strips are for sophisticated investors only, and I think it’s very dangerous to read too much into their price action. Either the yield on these things closely tracks the yield on 30-year Treasury bonds, in which case you’re in much safer territory with the more liquid plain-vanilla instrument, or else it goes completely haywire, in which case you’re simply on your own and good luck to you. (It’s not just 2008: note the crazy spike in strips yields one year ago last week.)

If you want to make a leveraged bet on the future direction of interest rates, there are lots of derivatives markets where that’s very easy. If you’re a community bank and you’re barred from making such bets, then you’re basically violating the spirit of those regulations by buying strips. They’re dangerous things, and it’s probably best to stay well away.

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