The Wall Street Journal-20080117-Funds Earn Their Strips- Zero-Coupon Bonds Help Strike Balance In Pension Plans
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Funds Earn Their Strips; Zero-Coupon Bonds Help Strike Balance In Pension Plans
Zero-coupon bonds are all the rage among pension funds in the U.S., Europe and even Asia, which have been snapping up these so-called Treasury strips as a way to better match their long-term liabilities with assets.
U.S. funds have led the charge, as regulatory and accounting changes pushed them to improve funding levels on their obligations -- current and future payments to retirees.
Demand has been further stoked by rising concerns about a deep slowdown in the U.S. economy, which will make it hard for stocks to repeat the impressive gains seen in the past few years. That pressures pension-fund managers to allocate more assets away from stocks into government debt, giving zeros a boost.
"We are seeing more clients moving into . . . liability-driven investments," said Jeffrey Hussey, head of U.S. fixed income at Russell Investment Group, one of the largest advisers to U.S. pension funds, in Tacoma, Wash. "Demand for zeros will continue to increase."
Strips, or the Treasury's Separate Trading of Registered Interest and Principal of Securities Program, are produced when a coupon- bearing bond is split into its principal and interest-rate payments.
The part made up of the principal is sold at a discount to its face value, so what investors earn in interest is the difference between the two. Because there is no regular payment until the debt matures, it fits nicely with the need of companies who have long-term fixed liabilities.
Zero-coupon government bonds have been around since the early 1980s. Merrill Lynch was the first dealer to create its own brand of zero- coupon government bonds in 1982, with other big Wall Street firms following suit. In 1985, the Treasury started selling strips as a direct obligation of the government. Since then, the market has expanded, with total volumes outstanding rising last year to about $2.4 trillion, from $2.28 trillion in 2006 and $2.145 trillion in 2005, according to Treasury data.
Legislation in the past two years forcing companies to improve the funding levels of their pension plans has fueled demand for strips. An accounting rule that came into effect in December 2006 and requires companies to treat unfunded benefits as liabilities on their balance sheet has further added to demand.
"What these regulations and accounting rules make them (pension funds) do is to match their assets with liabilities more closely," said Kurush Mistry, an interest-rate strategist in New York at Lehman Brothers. "The easiest way to attain more duration with the same dollar amount is to buy strips."
Duration is a key measure of portfolio risk, which measures in years a portfolio's sensitivity to interest-rate swings. Pension funds with long-term liabilities need assets with long durations.
After the past weeks' rally, government bonds of all types are looking rather expensive, and that includes strips. Investors entering the market need to be aware of that, said Alex Li, strategist at Credit Suisse.
Money Markets Loosen
In a sign that normality is returning to money markets, lending rates between banks have plunged this year, belatedly catching up with the rapid fall in government bond yields triggered by the Fed's easing in last year's second half.
The benchmark rate, the three-month London interbank offered rate, has fallen below 4% and yesterday was fixed at 3.95%.
Another gauge of credit risk, the TED spread -- which measures the gap between supersafe Treasury bills and dollar Libor -- has fallen to around 0.816 percentage point from a December high of 2.21 points on a three-month basis, suggesting there's less reluctance among banks to lend to each other.
Injections of massive amounts of cash by the world's largest central banks have helped ease strains.
"The coordinated efforts of the central banks are having a positive effect," said Jamie Jackson, portfolio manager at RiverSource Investments. Getting past the year-end turn also has reduced pressure, he added.
Confidence also has been helped along by the huge amounts of new money that are being poured into some of the largest banks, primarily by overseas investors. That has helped improve the amount of capital banks have in relation to their loans and debts.
Rate futures, meanwhile, continue to price in a cut of one half percentage point in the federal funds target rate this month. That has helped support the short end of the Treasury market, but longer-dated bonds ended lower, with the benchmark 10-year note down 4/32 point, or $1.25 per $1,000 face value, to 104 12/32 to yield 3.714%. The two- year note added 2/32 points to 101 14/32, yielding 2.500%. The 30-year bond shed 16/32 to 111 7/32 for a yield of 4.321%.
-- Matt Cowley
