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.