The Strips Are No Tease

06/01/2012 2:09 pm EST

Focus: BONDS

Igor Greenwald

Chief Investment Strategist, MLP Profits

Zero-coupon Treasury bond strips and related ETFs aren’t yielding much, but their capital gains from the flight to safety have been huge, writes senior editor Igor Greenwald.

This market is all about the zeroes. Or, more precisely, the ZROZ, as in the ticker for the PIMCO 25+ Year Zero Coupon US Treasury Index ETF.

According to StockCharts Technical Rank, it’s got more momentum than any other US-traded ETF. This is the sharp end of the bond rally, where the derisory yield offered by US bonds fades into insignificance beside the juicy recent capital gains.

The ZROZ is a proxy for Treasury strips, 30-year bonds stripped of their semiannual coupon and therefore traded at a sizable discount to face value. Because these only pay on the maturity date, their price is much more sensitive to changes in interest rates than bonds providing an income stream throughout.

The ZROZ is up 29% since April 3. Back then, the 30-year Treasury yield stood at 3.41%, while today the buying throng is eagerly settling for 2.56% per annum. A year ago, the 30-year yielded 4.15%. The ZROZ has gained 62% in that year.

The reasons are the same ones mentioned here yesterday: severe risk-aversion amid the financial train wreck in Europe and the resulting economic slowdown across Asia, coupled with a limited pool of investment assets deemed sufficiently safe to withstand such upheavals.

As noted in today’s Wall Street Journal, government bonds of countries still deemed creditworthy are in short supply, given the crush of investors clamoring to protect their principal. For this crowd, capital gains are icing on the cake, and low yields no deterrent to having some.

And as the price of “safe” debt soars, investors have begun scooping up riskier obligations in a reach for yield. Inflation-protected securities, agencies, munis, corporates—you name it—if it has a decent yield relative to the Treasuries and a reasonable risk profile, investors have been buying it in bulk.

Among this bunch, only the corporates would be exposed, albeit much less severely than stocks, to the very real risk that the renewed economic crisis will sabotage corporate profits.

Tellingly, biotechs and homebuilders have weathered the recent market correction better than all other industry groups, because no one holds these for this year’s earnings. The builders, for instance, are a call option on a housing recovery growing ever nearer as rates drop.

The biotechs are a call option as well, one that doesn’t expire until 2014, when health reform starts adding millions of the uninsured to Medicaid rolls. And in the meantime health-care costs are sure to keep rising and boosting the cash flow of the big drug companies that are the eventual buyers of biotechs and another stock sector holding up better than most.

Outside of housing and health care, investors now would like their stocks to act as much as possible like bonds, albeit with higher yields. All the usual recessionary staples are back in favor, from utilities and consumer staples to real estate investment trusts, pipeline partnerships, and mortgage coupon clippers.

Still, none of those as hot as ZROZ, because if the 30-year yield can drop three-quarters of a point in two months, why not another point by Labor Day as the global economy sputters?

Much of what’s above was written before this morning’s dismal jobs report, and the ZROZ had responded to the labor pains with another 2.5% gain.

Any uptick in bond yields in the near term in response to whatever bailing measures officialdom will be offering soon enough are probably a buying opportunity in the ZROZ and the comparable Vanguard Extended Duration Treasury ETF (EDV).

This trend will turn eventually, as all trends must. But there is little reason to expect that in the near future.

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