Demand for Strips, created when Wall Street banks separate the interest payments from the principal of US debt and sell each at a discount, has boosted the amount outstanding to an average $211bn this year

Bloomberg

New York

An obscure corner of the $12.4tn market for US government debt is providing one of the clearest signs yet that bond investors are writing off the threat of inflation for years, if not decades, to come.

Demand for Strips, created when Wall Street banks separate the interest payments from the principal of US debt and sell each at a discount, has boosted the amount outstanding to an average $211bn this year, the most since 1999, data from the Treasury Department show. The securities, the most vulnerable to inflation of all US government bonds, posted the biggest returns this year by rallying almost 50%.

While forecasters say the world’s largest economy will grow at the fastest pace in a decade next year and expose the securities to the deepest potential declines, debt investors are signalling their scepticism as commodities plunge and slowdowns in Europe and Asia threaten the US recovery. Last week, the bond market’s outlook for inflation over the next three decades fell below 1.9% annually, the lowest in three years. “The marketplace feels pretty comfortable that inflation is going to be contained,” Tom Girard, the head of fixed-income investments at NYL Investors, which oversees $200bn and owns Strips, said by telephone on December 11. There are still “some headwinds that the economy is facing.”

Investors’ expectations for consumer-price increases are diminishing as the Federal Reserve debates how soon to raise its benchmark interest rate, which has been held close to zero since 2008 to support demand in the economy.

The central bank’s policy makers will meet over two days starting December 16 and discuss their pledge to keep rates low for a “considerable time.”

The Fed’s preferred measure of inflation has also fallen short of its 2% goal for 30 consecutive months, even as the central bank inundated the US economy with almost $4tn of cheap cash since the financial crisis with its bond- buying program known as quantitative easing.

The lack of price pressures has caused bond investors to pour into Strips, short for separate trading of registered interest and principal of securities. That’s boosted the average amount outstanding by about 20% since 2009.

The longest-dated principal portions have returned 47.2% this year, index data compiled by Bank of America Corp show. Only twice since 1997 have they posted bigger annual gains. The advance is also more than quadruple the return for the Standard & Poor’s 500 Index, which has climbed 10.5%.

Because Strips are sold at a discount, the longest-dated securities offer the highest yields among US government bonds.

For example, those due May 2044 trade at 43.1 cents on the dollar. The buyer, who doesn’t receive any interest payments, would receive full face value at the end of 30 years for an annual return of 2.86%. That compares with a yield of 2.74% for interest-bearing 30-year US bonds.Their outperformance this year shows bond investors still aren’t sold on the notion the US economy is on the cusp of creating the kind of wage growth that pushes up prices, even as employers add jobs at the fastest pace since 1999.

While average hourly earnings rose 0.4% in November, the most since June of last year, in five of the prior eight months they were flat or rose just 0.1%.

On an annual basis, growth in hourly wages in the past five years has been the weakest over the course of any expansion since at least the 1960s, data compiled by Bloomberg show.

In the bond market, that’s being reflected in falling expectations for inflation.Based on yields, the outlook for consumer-price increases over the next five years has fallen almost a percentage point since its high in June to a four-year low of 1.13%.

Inflation expectations over 30 years fell below 2% on a closing basis last month for the first time in three years.

“Until wages pick up, it’s going to be harder” for inflation to accelerate, Bill Irving, a money manager at Fidelity Investments, which oversees $35bn in fixed income, said in a Dec. 10 telephone interview from Merrimack, New Hampshire. “Demand will remain strong for Strips.”

Buying the securities now isn’t worth the risk, said Gerard Fitzpatrick, the global chief investment officer of fixed income at Russell Investments, which oversees $275bn.

Inflationary pressures will rise as unemployment drops and the economy gains more momentum, prompting the Fed to lift rates, he said. The US economy will expand 3% next year, which would be the most since 2005, based on the latest Bloomberg survey of economists.

“The best returns are behind us,” he said by telephone on Dec. 10 from Seattle.Any selloff would hurt Strips, which are primarily created from 30-year bonds, the most. The securities due in May 2044, which yield 2.86%, would lose about 21% if yields rose as much as forecasters anticipate for long-dated debt by the end of 2015, data compiled by Bloomberg show.

That’s more than the losses that comparable 30-year bonds would suffer and about four times the 5.2% decline benchmark 10-year notes would incur.