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Investors Chase Returns in Risky Zero-Coupon Bonds

04/17/2015 | 04:53pm US/Eastern
By Min Zeng 

Investors are rushing into the riskiest and most volatile corner of the U.S. government bond market in search of bigger returns, as worries about higher interest rates abate.

Zero-coupon Treasury bonds, which don't offer a stready stream of income, that mature in more than 25 years have handed investors a return of 5.79% year to date, according to data from Barclays PLC. That compares with a return of 4.36% for regular Treasurys of similar maturities and 1.94% for the U.S. government bond market as a whole.

Because bondholders don't receive interest payments on zero-coupon bonds until the debt matures, prices of these bonds--also known as just "zeros"--would fall sharply if short-term rates rose, traders say. The effect is even more pronounced for long-duration zeros.

But these securities' strong performance so far this year, coming on top of a 48% return in 2014, shows that many fund managers are shrugging off these risks in the race to grab higher yields.

Recent data indicate that the U.S. recovery has hit a soft patch, and Federal Reserve officials have downplayed the chances of a rate increase in June. That has pushed back investors' expectations on the timing of a rate increase.

George Goncalves, head of U.S. rates strategy at Nomura Securities International in New York, points out that zero-coupon bonds tend to perform particularly well when stocks stumble.

"These bonds should continue to maintain a value advantage versus stocks, " especially if "there ever was a real stock market correction," Mr. Concalves said.

On Friday, the yield on the 30-year zero-coupon bond fell alongside other haven Treasurys as stocks in the U.S. and Europe sold off on worries over Greece's debt and weak earnings in the U.S. In 2008, when the S&P 500 plunged 37%, zero-coupon bonds maturing in more than 25 years handed investors a 77% return. Yields fall as prices rise.

The yield on a 30-year zero-coupon bond was 2.611%, down from 2.8% two months ago, but higher than 2.504% on the regular 30-year Treasury bond.

The higher yield is a lure for investors who are confronted with record-low bond yields, some of them negative, in other developed markets. The 30-year German government bond closed on Friday to yield a record low 0.448%, and the 30-year Japanese government bond yielded 1.280%, near a record low.

"The reach for yield remains the modus operandi of bond investors," said Erik Schiller, senior portfolio manager for global government bonds at Prudential Financial Inc.'s fixed-income unit, which oversees $543 billion.

Long-dated zero-coupon Treasury bonds, along with regular similar-maturity Treasury debt, are favored by pension funds and insurance companies, which need high-grade bonds to match their long-term obligations.

To be sure, some investors are wary of jumping into an asset known for its big drops as well as its big jumps. In 2013, when bonds sold off broadly in anticipation of the Fed trimming back its bond-buying program, long-term zeros lost 22%. In 2009, as the U.S. was coming out of a recession, these bonds dived 43%.

"Right now, we do not see a lot of value in long-dated zeros," said James Ong, a portfolio manager at asset management firm Invesco Ltd., which has $798.3 billion assets under management. "While we believe interest rates will remain low for a long period of time, valuations already reflect historically low growth expectations and low inflation."

Among U.S. government bonds, zeros are the most sensitive to changes in interest rates, a key concern for investors as the Fed signals its intention to raise rates for the first time since 2006. An investor doesn't receive any payments from zeros until they mature. So when rates rise, investors in zeros miss out on the opportunity to reinvest interest payment in higher-yielding debt.

"In a bull market, zero-coupon bonds always outperform, but in a bear market, they should be the worst performers," said Ted Ake, manager of fixed income at Willingdon Wealth Management which has $200 million assets under management.

Zeros are a small slice of the $12.6 trillion U.S. government bond market. At the end of March, the total outstanding value of zero-coupon Treasury bonds stood at $212.billion, up from $204.7 billion at the end of 2013.

Unlike other Treasury bonds, zero-coupon debt isn't auctioned off by the U.S. government. Investors can only buy zeros through financial institutions that create these instruments by slicing a regular 30-year Treasury bond and its anticipated interest payments into separate components.

Zeros are sold at a discount but are redeemed at face value. The difference between the price paid and the price at which the security is redeemed represents the accumulated interest.

Write to Min Zeng at min.zeng@wsj.com

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