Everybody Wants Duration Even as Fed Normalization Draws Near

(Bloomberg) -- Investors can't get enough of the longest maturity U.S. bonds even with the Federal Reserve set to embark on its next step toward normalizing interest rates.

While higher rates usually erode the value of long-dated debt more, expectations for only a gradual increase in yields and tepid inflation have investors such as pension funds seeking to put money to work in a low-return world.

“There is still really, really strong demand for Treasury bonds out there,” said Ben Emons, chief economist and head of credit portfolio management at Intellectus Partners. “There's a mix of structural factors -- from pension funds who remain underfunded -- to global investors faced with low or negative yields abroad and given inflation is low. This would all be different if inflation was higher -- but it's not.”

The amount of Treasury notes and bonds split into principal- and interest-only securities, known as Strips and a favorite of the asset-liability manager community, jumped to a record in August. Strips, short for separate trading of registered interest and principal of securities, have greater duration than their note and bond counterparts, meaning they suffer steeper losses when rates increase, and greater gains when rates fall.

“The pension and insurance industry is a bullet buyer -- they never really relent on trying to get duration in all shapes and sizes,” said Thomas Simons, a money-market economist at Jefferies LLC. “This is not going to change anytime soon because of the global demographics and generally aging population. This demand does sort of put a cap on how far nominal 30-year yields can go higher.”

The 30-year Treasury bond yield trades at 2.89 percent, below the 3.49 percent level it averaged over the last decade, yet up from a record low set in July 2016 at 2.09 percent.

Investors are hedging the risk. A JPMorgan Chase & Co. survey shows investors have accumulated the largest short position relative to their benchmark since 2006.

Market Math

Loading up on duration, a measure of how much bond prices move with each yield change, can be risky if rates rise abruptly. With yields this low, a jump of one percentage point would lead to about a $452 billion decline in value for the Bloomberg Barclays U.S. Treasury Index. The index has returned 2.22 percent this year, while a global sovereign index has gained 5.82 percent.

Duration has been rising in recent years (as seen in the chart below) as traders and investors have sought the higher yields of long-term debt.

Asset managers are also piling into long-term Treasury futures. Net long wagers in the the CME Group Inc.'s ultra Treasury bond futures contract have more than doubled in the last year, the Commodity Futures Trading Commission data show. The ultra contract designates Treasuries with maturities of 25 years or more for delivery.

The same message comes through in the mutual fund and ETF flows in recent months. After outflows surfaced in the months following Donald Trump's presidential win, they have reversed course. August marketed the eighth consecutive month of net inflows to long-term mutual funds and ETFs, according to EPFR Global -- whose weekly data shows inflow in the first three weeks of September as well.

All of these forces, which Deutsche Bank strategists say shows ample evidence of demand for long-end duration, is the “strongest in years” and is helping keep the back end of the yield curve extra flat.

“The 10s30s yield curve is flat relative to what our models and what conventional economic variables would say,” according to Steven Zeng, a rates strategist at Deutsche Bank Securities. “We suspect that long end demand -- indicated by Strips outstanding the asset managers positioning in the ultra-bond contract plays a role.”

To contact the reporter on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net.

To contact the editors responsible for this story: Boris Korby at bkorby1@bloomberg.net, Jeremy Herron at jherron8@bloomberg.net, Dave Liedtka, Andrew Dunn