Investors may not get periodic interest payments from zero-coupon bonds. But do they get value from them in today’s low-rate environment?
Opinions vary. But there’s no mistaking the fact that traders report a lot of activity in zeros lately as investors look to them for yield.
As a $40 billion sector of the municipal bond market, zeros have been trading cheaply to current coupon bonds on a historical basis, according to one report. In addition, their spreads have been tightening noticeably over the past three months, market watchers note.
One industry analyst sees value in their scarcity. He also believes that zeros’ relative cheapness will reverse course when interest rates eventually rise, and that, adjusted for duration, zeros could outperform current coupon munis as they do.
But another market watcher said zeros are far too illiquid a security for most investors, and generally underwhelm on price performance.
One investor bought zeros two years ago and watched them rally hundreds of basis points since. Now he’s been unloading half of those zeros in his portfolio to lessen his risk exposure.
Another buy-sider said that even though spreads have tightened, performance varies noticeably among names. Still, he added, liquidity in zeros has improved because supply has been more manageable.
Opinions aside, market pros agree on one thing: “spreads have tightened, mostly in the last three to four months,” said Michael Kalinoski, director and portfolio manager with BlackRock’s municipal bonds group. What’s more, he added, there has been some good performance, certainly on some names more than others, such as California community college districts and school districts.
Some of that could be due to the “chilling effect” that resulted from California State Treasurer Bill Lockyer’s comments about capping the maturity of issued bonds to 25 years and the ratio of the amount borrowed to principal to four times. His comments could prompt some issuers to postpone selling or proposing to sell zeros.
“And so the market has anticipated less supply, which has helped performance of those specific names,” Kalinoski said.
By definition, zeros are bonds issued at a steep discount from par that do not make periodic interest payments. Instead the zero investor receives, at call or maturity, one payment that includes principal and interest at the rate represented by the offering yield at issuance.
“Zeros tend to be the type of bond that people are likely to avoid when they’re concerned about interest rates rising,” said Christopher Ihlefeld, a portfolio manager and managing director at Thornburg Investment Management. “And then, conversely, they attract a lot of interest when interest rates are falling, because they tend to be higher-duration positions that you can trade into and out of.”
Before the financial crisis, zeros and coupon munis were trading very close to one another, according to a Citi research report citing Municipal Market Data numbers. Until 2008, the yield differential for 10-year and 30-year bonds ranged from 10 to 50 basis points.
But in 2008, following Treasury yields, MMD triple-A yields rallied while zeros underperformed, according to Mikhail Foux, a municipal analyst at Citi. Through the end of February, 30-year zeros were about 95 basis points rich to their 10-year average yield in absolute terms, MMD numbers indicate. But 30-year 5% coupons were 160 basis points richer to their 10-year average yield in absolute terms, Foux wrote.
“Due to this underperformance, currently both 10-year and 30-year zeros trade at some of the highest yield discounts and highest yield ratios compared to coupon MMDs with similar maturities,” Foux wrote.
Larger zero trades in 2013 show another reason for muni cheapness, according to Chris Mier, a strategist in the analytical services division at Loop Capital Markets. Through March 4, there were 1,958 zero coupon trades of more than $1 million.
Of those, almost 72% were trades of zeros issued in California, Illinois and Puerto Rico. Bonds from these issuers are not always welcomed enthusiastically by retail buyers, Mier said, although California is improving its image. What’s more, there were only 172 trades — or 8.8% of the total — that were non-call, rated as high as double-A by one rating agency, and not from California, Illinois or Puerto Rico.
“It looks, based upon superficial inspection, that the ‘cheapness’ of the vast majority of the trades is explained by the state of origin, call-ability and ratings,” Mier said.
Nonetheless, Foux argues that, when adjusted for duration, zeros could outperform coupon munis in a rate selloff, as they would be protected by the cushion created by their relative cheapness to their 10-year average yields.
In addition, scarcity of supply would help, Foux said. Zero issuance has been shrinking, and could dwindle even more going forward. For example, school district zeros comprise roughly 90% of the market, he said, and their issuance appears likely to be seriously restricted in the future, particularly by legislation under consideration in California.
Finally, a sizable group of investors continues to favor zeros, because many trade at low dollar prices, compared to their accreted values, Foux said. Holders of zeros benefit from higher convexity — or, losing their value more slowly in a rising rate environment — and the absence of reinvestment risk compared to coupon bonds of similar duration, which are beneficial in a low-interest-rate environment.
“There’s a lot of activity in the sector,” Foux said. “And taking that into account, it’s fair to say that in duration-adjusted terms, or in yield terms, if you have a selloff in rates, zeros will actually outperform coupon bonds.”
BlackRock’s Kalinoski agrees with a couple of those points. Overall supply of municipal zeros has been shrinking significantly over the years, lending them a degree of scarcity, he said.
Also, their relative liquidity has improved compared to coupons. But that’s due to the fact that overall supply has been very manageable in the municipal market, according to Kalinoski.
In addition, the substantial yield pick-up versus currents has left zeros in fairly strong hands, which has dampened selling pressure on them. And despite what others say, there is a core number of investors who strongly favor the product, Kalinoski said.
“And I think we’ve definitely seen some new buyers, given that it’s a struggle out there to find yield in the municipal market,” he added. “And this is one type of security that does provide additional yield. And that’s definitely opening up some new investors to looking at these types of securities.”
Others, though, have reached different conclusions about zeros. For Matt Fabian, a managing director at Municipal Market Advisors, buying zeros to outperform represents more of a speculative call.
“Historically, zeros don’t outperform anything on a total return basis,” he said. “Zeros provide great, but illiquid, income.”
Zeros possess several flaws, Fabian said. They’re some of the least liquid instruments in the bond market, and they lack broad investor demand. And, by and large, he said, zeros will underwhelm investors with their price performance.
“Away from California, zeros are typically used by weaker issuers to cram more bond proceeds into a tight cash flow,” Fabian said. “So there’s also a credit aspect that is endemic to that structure.”
Loop’s Mier seconded Fabian’s skepticism about zeros’ ability to outperform current coupons if rates rise. For a zero to outperform a coupon-bearing bond in a rising-rate environment, generally speaking, the yield curve must flatten sufficiently — which would drive the zero spread tighter to the coupon curve — to offset the considerable difference in duration.
But the Federal Open Market Committee “is going to stop buying bonds before they start raising the fed funds rate,” Mier said. “Thus a flatter curve under a rising rate scenario seems very unlikely.”
Investors at Thornburg take a value approach to zeros, Ihlefeld said. Around 2011, the firm bought zeros at 7%; today, it’s selling half of those positions in the mid-fours to remove some risk. During the interim period, the shrinking spreads brought double-digit returns on an annualized basis
“We’re doing that with the mindset of there is strong demand for zeros today,” Ihlefeld said. “There’s effectively a yield-grab going on out there.”
But Thornburg’s taste in zeros today focuses more on the intermediate part of the curve, favoring 10-year zeros versus 20-year zeros. The reason: it still believes that the yield curve is going to be fairly steep, at least until the market starts to see tangible evidence of the Fed raising its anchor on the short end.
When Thornburg considers the yield relative to the risk measure of duration, zeros just aren’t a safe bet for most investors, Ihlefeld said. The exception to that might be zero coupon bonds in the five- to 10-year range, which are still outperforming.
“The yield curve between one and 10 years is still considered fairly steep,” Ihlefeld said. “And zeros are great if you’re looking for opportunities that optimize returns from the roll-down effect of bonds aging. You can go underwater in owning long-term zeros very quickly.”
In addition, each year zeros sit in a portfolio, the relative risk measure declines at an increasing rate, Ihlefeld said. That is one reason why Thornburg feel more comfortable owning zeros in the intermediate space than out long.
Ihlefeld owns a mix of 6% of zeros across all of his portfolios. He finds that they complement premium coupon bonds well because they lower the price premium of the portfolio.
Zeros’ liquidity depends on the market: liquidity withers as concerns of rising interest rates grow. Today, the market still sees a rally, Ihlefeld said, as the risk curve has flattened. And zeros have been among the best-performing bonds in the municipal market, he added.
But do zeros have a big enough cushion to protect them from more rising interest rates? “There might be some truth to that,” Ihlefeld said. “But if zeros haven’t recovered as much, they’ve recovered quite a bit. Do you really want to try to time the market?”