Think Twice About These 2 Bond ETFs

May 08, 2014

The Phantom Income

Accretion is considered a form of interest income by the Internal Revenue Service even though no cash is actually received until maturity. What this means is that despite not having actual cash income before maturity, bondholders still need to pay federal income tax on accretion—commonly referred to as phantom income—on an ongoing basis. As such, holders of zero-coupon bonds still need to set aside cash in advance to meet those ongoing tax payments.

Zero-coupon Treasury ETFs offer broad exposures and tax liability management in one package, with an annual expense ratio of less than 15 basis points ($15 for each $10,000 invested). Conveniently, notwithstanding the lack of ongoing interest income from bonds, both ZROZ and EDV make quarterly distributions that investors can use to match their tax payments.

Portfolio managers (PMs) often use simple accretion models to calculate this phantom “interest income.” At each rebalance, the PM will sell the bonds that roll off the index due to maturity requirement.

With the proceeds, the PM will purchase new bonds that have just entered the index. However, the PM will purchase slightly fewer new bonds and return some of the proceeds as a cash distribution. Voila! There is your distribution, which can be used to pay your taxes, unless you’re investing through a tax-advantage account such as an IRA account.

The Eye-Popping Performance Of ZROZ And EDV

Characteristics And Attribution Analysis
Ticker Total Return Modifed Duration YC Change Return
YC Change Return
(% of TR)
Coupon Income Return YTM
AGG 2.68% 5.52 1.32% 49.31% 3.59% 0.96% 2.25%
GOVT 1.85% 4.96 1.07% 57.95% 2.49% 0.76% 1.38%
TLT 10.54% 17.23 9.30% 88.26% 3.59% 0.01% 3.39%
ZROZ 18.93% 26.85 18.68% 98.63% 0.00% 0.00% 3.58%
EDV 17.15% 24.82 16.21% 94.51% 0.00% 0.00% 3.58%

As the characteristics and attribution analysis has shown, both ZROZ and EDV have very long durations, longer than iShares 20+ Year Treasury Bond ETF (TLT | A-76) and much longer than iShares Core Total U.S. Bond Market ETF (AGG | A-97).

Their long durations thus make them very sensitive to interest-rate changes.

Despite all the talk about rising interest rates, the long end of the yield curve actually came down in the first quarter of 2014, as investors continued to look for extra yield in a low-inflationary environment, and also in a flight-to-safety trade in response to geopolitical unrest in Ukraine.

ZROZ hunts in the 25-plus-year space, while EDV hunts in the 20- to 30-year space. Being the longer-dated of the two, ZROZ has longer duration, and again, is more sensitive to interest-rate changes than EDV and thus benefited more from the drop in yields on the long end of the curve. ZROZ derives more than 95 percent of its return from the changes in the yield curve.

Mean Reversion

But remember, duration can cut both ways. Economic recovery can pick up steam as the impact of severe weathers fades. President Putin might come to his senses for a rational resolution of the crisis in Ukraine. If both scenarios materialize, rates are likely to resume an upward path toward historical norm.

The bottom line: The decline in yields on the long end of the curve so far has benefited long-duration bets such as ZROZ and EDV. But don't get caught chasing performance.

If you already own them, you can probably hold on to them for a bit longer. They might just have a bit more room to run until a confirmed robust economic recovery materializes, or the crisis in Ukraine resolves.

But don’t expect the same impressive performance as the past quarter. If you don’t own them already, think twice. Duration can cut both ways: Just look at their awful performance in the second half of 2013.

At the time this article was written, the author held no positions in the securities mentioned. Contact Howard Lee at [email protected].

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