Think Twice About These 2 Bond ETFs

May 08, 2014

Beware the rallying long end of the fixed-income market.

Underpinned by a lackluster recovery, low inflationary pressure and geopolitical unrest in Ukraine, long- dated bonds that serve as a safe haven have enjoyed an impressive rally in the first quarter of 2014.

In particular, the Pimco 25+ Year Zero Coupon U.S. Treasury Index Exchange-Traded Fund (ZROZ | C-51) and the Vanguard Extended Duration Treasury ETF (EDV | C-39) have absolutely crushed everything in the bond ETF universe. Both exclusively target the zero-coupon Treasury bond space.

As of April 25, ZROZ and EDV have returned almost 19 percent and more than 17 percent, respectively, while the S&P 500 Index has returned less than 1 percent.

For now, the bullish bond dynamic that prevailed in the first quarter is still in place, as investors worry about how and when the Russia-Ukraine crisis will resolve and as they respond to the Federal Reserve’s latest pledge to keep short-term interest rates pinned at near-zero levels. But that only serves to add to anxiety about how swiftly ZROZ and EDV are likely to correct once sentiment reverses.

YTD_TR

Mean-Reverting Tendency: What Goes Up Must Come Down

But given the continuing improvements in the economy and a general expectation of rising rates, ZROZ and EDV are unlikely to repeat their impressive performance. So don’t chase performance.

Still, it’s nonetheless beneficial to understand the unique structure, tax advantage and the source of performance of a zero-coupon Treasury ETF in case you want to make a long-duration bet or need a viable flight-to-safety vehicle in response to a geopolitical event in the future.

Zero-Coupon Treasury Bond

A regular coupon-bearing Treasury bond basically has two components: the principal (paid in full at maturity); and coupons (periodic interest payments).

A zero-coupon Treasury bond is created by stripping out the coupons of a coupon-bearing Treasury bond into a separate income stream. The resulting product—a zero bond—is traded as a separate security. A zero bond doesn’t provide periodic interest payments; it only repays bondholders the full face value at maturity.

Because of the lack of periodic cash flows and the inverse relationship between a bond’s price and its yield, a zero-coupon bond usually trades at a deep discount to its face value to generate comparable yields to its coupon-bearing counterparts. As the zero bond bought at discount matures, its price will appreciate gradually—accretion—to its face value.

 

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