But public funds are looking elsewhere
Demand for U.S. Treasury STRIPS is soaring, fueled by rising interest rates and U.S. pension plans' desire for asset-liability matching, industry sources said.
Treasury STRIPS jumped to a 17-year high at the end of 2016, reaching $233 billion compared with $215 billion a year earlier, according to Bloomberg data provided by Bank of America Merrill Lynch. By Feb. 28, such STRIPS available in the market grew to $241 billion.
With interest rates going up, U.S.-based corporate defined benefit pension funds seeking duration have been particularly enthusiastic about STRIPS. For pension funds, they are a natural fit — a strategy that is used to secure cash flow for the future payment of liabilities and protect against interest rates risk, sources said.
STRIPS don't disappoint on the performance front, either. The Barclays U.S. 20+ years STRIPS index annual return was 9.9% during the three years ended Feb. 28, compared with 2.6% achieved by Barclays U.S. Aggregate Fixed Income index, according to Bloomberg data.
“The buyers of 30-year U.S. Treasury STRIPS have increasingly been domestic U.S. pension funds,” said James McAlevey, senior portfolio manager at Aviva Investors in London.
Sources expect demand to continue, if not grow, as the Federal Reserve gears up for more hikes this year, following the most recent one on March 15 that pushed the federal funds rate to a 0.75% to 1% range.
Pension fund consultants agree there will be more demand coming from corporate plans.
“STRIPS are the most capital efficient way to obtain interest rate exposure short of accessing the derivatives market,” said David Murad, managing director at Rocaton Investment Advisors LLC in Norwalk, Conn.
Mr. Murad declined to name clients that are pursuing the strategy.
But rate-hike anticipation has not been the sole factor in demand for STRIPS, which remove, or strip out, the coupon from the principal.
Higher premiums from the Pension Benefit Guaranty Corp. also “motivated … pension plans to buy long-dated STRIPS,” said Shyam Rajan, Bank of America Merrill Lynch's head of U.S. rates strategy in New York. Higher PBGC premiums pushed pension plans to adopt glide-path derisking strategies. As funded ratios improve due to higher interest rates, pension funds tend to buy more STRIPS.
“As pension funds embarked on derisking and shifted away from equity to cash bonds, interest in long-dated STRIPS has continued to climb,” Mr. Rajan said.
Still, while analysts proclaim the demand for STRIPS from corporate defined benefit plans is here to stay, some public plans are spotting value elsewhere.
The $63.2 billion Massachusetts Pension Reserves Investment Management Board, Boston, decided to move away from STRIPS in February.
“PRIM invested in STRIPS to reduce portfolio risk given their historically negative correlation with equity markets, but now we're exploring new ways to obtain that insurance against equity risk,” said spokesman Eric Convey “We bought STRIPS several years ago and they did extremely well for us to offset equity risk, but now we are reducing our allocation to 2% of the fund from 5%.”
PRIM's BlackRock (BLK) STRIPS portfolio returned 30.06% for the fiscal year ended June 30, 2016. As of that date, the STRIPS holdings by the Massachusetts Pension Reserves Investment Trust were valued at $3.3 billion.
Corporate plan sponsors are investing in STRIPS to match liabilities of their pension funds, while public funds might have moved away from them in order to reduce duration by investing in Treasury inflation-protected securities, according to Phillip Nelson, principal and director of asset allocation at NEPC LLC in Boston.
Kevin Moose, senior portfolio manager and head of rates at the $186.2 billion Florida State Board of Administration in Tallahassee, said in an email: “Any core fixed-income strategic duration extension beyond the 10-year tenor would likely not be expressed using U.S. Treasury STRIPS, but more liquid instruments such as the on-the-run 30-year U.S. Treasury bond or ultralong bond futures.”
But although public pension funds might be going for other instruments, STRIPS offer a chance to build a more diversified portfolio in regard to risk, said Daniel Morris, head of U.S. portfolio solutions at Schroders in New York. “Holding STRIPS may allow a pension fund to build a more flexible and diversified portfolio including a wider opportunity set of bonds to incorporate, such as BBB-rated corporate bonds.”
One hindrance of long-dated STRIPS is the fact that initial and ongoing transaction costs for holding a STRIPS portfolio are significant relative to a typical long-term Treasury portfolio. “We would expect a long STRIPS portfolio to incur initial transaction costs in the 15 to 30 basis points range and ongoing costs in the five to 10 basis points range,” Mr. Murad said.
While domestic demand for STRIPS on the long end of the curve has grown, non-U.S. investors aren't as enamored because of costs.
One of the drawbacks for European investors is the high currency hedging cost they have to bear by purchasing U.S. securities. Sources said European investors are instead more likely to buy the debt of peripheral European Union countries, which eliminates foreign exchange costs.
Mr. McAlevey also saw Japanese investors take a step back from the U.S. Treasury market in recent quarters. “Japanese investors started scaling back their purchases in the third quarter last year as domestic yields normalized and they found domestic yields more attractive,” he said.