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Deals to Be Had in U.S. Treasury Bonds

   

Treasury bonds come in all kinds of flavors and sizes. Theoretically, investors should examine their different characteristics and determine a market value for each. But a University of Michigan professor recently found a glitch in prices of U.S. Treasury bonds that could help investors make a risk-free profit.

Peter Carayannopoulos examined callable Treasury bonds, which make up a fifth of the total Treasury bond market. Callable bonds, as their name implies, allows the issuer-in this case the Treasury-to redeem bonds during the five-year period prior to the maturity date of the bond. Most of the current outstanding callable bond issues were issued between 1973-1984, with coupons ranging from 7 percent to 14 percent and come due between 1998 to 2014.

Carayannopoulos found something quite strange. Bonds with relatively low coupons are "overpriced by the market." What he means is that considering that the government can call the bonds in, there are other equivalent Treasury securities that are cheaper than callable bonds but aren't any riskier.

This anomaly occurs in callable U.S. Treasury bonds, most often with a coupon of 8.75 percent or less and in particular, the Treasury bonds that mature in February and November of 2007, which have coupons of 7.625% and 7.875, respectively.

If you own these or other low coupon, callable bonds, you can sell them, buy the portfolio of strips that replicates the cash flows of the minimum of the equivalent of short and long bonds, and profit in the process. Strips are zero-coupon bonds created from either the principal or individual coupons of U.S. Treasury bonds. The task is not as difficult as you might think. If you want to buy strips that duplicate a bond with a 10 percent coupon maturing in a year, for example, you would buy 5 percent of the strip maturing in six months and 105 percent of the strip maturing in one year. That way you get the same cash flow as the bond with the 10 percent coupon--$105.

Bottom line: all bonds are not alike and you can find great values by being careful about how you construct your portfolio.

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