Treasury market turmoil puts zero-coupon machine in reverse

The U.S. debt market's most violent month in years spurred a steep decline in the amount of zero-coupon bonds, Treasury Department data show.

Treasuries held as STRIPS — a product that dealers create by divorcing a bond's principal payment from its coupons and re-selling it as a zero-coupon security — slumped $15.1 billion in March, the largest-ever slide, the data show.

These bonds had risen to a record $339.6 billion in February.

The drop accompanied a huge rally in Treasuries. Pension funds — a big customer for STRIPS — likely sold bonds and bought stocks to rebalance their portfolios for month-end after bonds outperformed massively. And the Federal Reserve's resumption of quantitative easing also created a market for whole bonds reconstituted from their component parts. Those purchases began on March 13 and totaled $1 trillion by the end of last week.

"Clearly there was a seller of seasoned zeroes as clients lightened up on fixed income," said BTG Pactual Asset Management's John Fath, who was a STRIPS trader for most of the 1993-2008 period when he worked for primary dealers. "Reconstitution of these zeroes became doable with the Fed instituting QE."

Yield curve volatility, a main driver of the economics of STRIPS reconstitution, also played a role, Fath said.

One of the most heavily reconstructed bonds in March was an old 30-year maturing in November 2045, with $2.21 billion reconstituted. The Fed held $7.78 billion of it as of April 1, up from $231.5 million during the first week of March.

However, Treasury Department data suggest that new STRIPS remained in demand in March. Dealers reconstituted $35.7 billion of STRIPS during the month, meaning that they also created about $20 billion of new STRIPS to limit the monthly decline to $15 billion.

Most of the net reconstitution activity was concentrated in bonds maturing in 22 to 28 years, "as opposed to the very long end of the curve where all the stripping activity had occurred more recently," J.P. Morgan Chase strategist Jay Barry said in a note.