In the first half of the year, it’s been all about duration.
The first half of 2014 has been an interesting period for the fixed-income market. The widely forecast “bond market Armageddon” didn’t happen. Instead, a lackluster U.S. economic recovery, a rather tame inflation outlook, a very accommodative European Central Bank and geopolitical unrests helped drive down Treasury yields and lift prices.
The benchmark U.S. 10-year yield retreated to about 0.50 percent below where it started the year. The drop in yields boosted the performance of long-duration bond ETFs the most.
Here are the top five best-performing fixed-income ETFs of the first half of 2014.
5. iShares 20+ Year Treasury Bond ETF (TLT | A-80)
Total return: +12.85 percent; Effective duration: 18.11 years
TLT invests in Treasury bonds with at least 20 years remaining in maturity. Since Treasurys are perceived to be risk free, it is a pure duration play.
TLT benefited both from ongoing geopolitical unrest centered on Ukraine and Iraq, as well as from muted inflation forecasts. Believing inflation would not be a significant source of head winds, investors rushed to safe-haven Treasury funds like TLT to lock in yield when Ukraine descended into seemingly unending chaos.
Total return: +15.05 percent; Effective duration: 23.56 years
LTPZ invests in Treasury inflation-protected securities (TIPS) with at least 15 years remaining in maturity.
Similar to TLT, it is a pure duration play but with inflation protection. However, do not mistake the performance in TIPS as a sign of imminent inflation. It is the spread between nominal Treasury and its TIPS counterpart—the breakeven inflation rate—that is supposed to reflect inflation expectation.
Due to market inefficiencies (liquidity premia and inflation risk premia), the breakeven inflation rate has not been a good forecast of future inflation, especially in inflation over longer horizons.
3. SPDR Nuveen Barclays Build America Bond ETF (BABS | C-99)
Total return: +15.09 percent; Effective duration: 12.48 years
BABS invests in the Build America bonds (BABs), which are essentially municipal bonds subsidized by the U.S. government.
The muni space benefited in the first half from a decline in default rates, and record low issuance. This created steady demand, but constrained supply, net-net pushing up prices and driving performance.
Unlike its conventional muni counterparts, BABs generally have longer maturities and durations, and are noncallable. You can read more about that in a blog I recently wrote, Build America Muni Bond ETFs Hot For Now, to get a better understanding of BABs.
The ETF BABS, in particular, serves up the longest duration among the three ETFs that cover the space. Therefore, it is not surprising it is the best performer of the bunch so far.
Long Duration But Super-Charged
The top two bond ETF performers so far this year both hunt in the Separate Trading of Registered Interest and Principal of Securities (STRIPS) space, taking duration exposure to the extreme.
You can read more about that in another blog I recently wrote, Think Twice About These 2 Bond ETFs for insight on STRIPS and the mechanics of zero-coupon Treasury ETFs. The gist here is that because of these mechanics, it makes sense that they benefited the most from a decline in long-term yields.
2. Vanguard Extended Duration Treasury ETF (EDV | C-46)
Total return: +19.94 percent; Effective duration: 27.13 years
EDV holds STRIPS, which are zero-coupon Treasury bonds created by stripping coupon payments from principals with maturities between 20-30 years.
Since STRIPS make no intermediate coupon distribution, they are bought at very deep discounts; hence, they’re very sensitive to changes in interest rates. It is a pure duration play on a different level entirely.
1. Pimco 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ | C-55)
Total return: +22.31 percent; Effective duration: 29.45 years
Similar to EDV, ZROZ hunts in the STRIPS space. However, it extends its duration exposure by holding STRIPS with at least 25 years remaining in maturity. It is a super-charged duration play.
While ZROZ has had an impressive run in the first half of 2014, things can turn ugly rather quickly when yields start to normalize from historical lows. Consider that it was massacred in the second half of 2013 when the market reacted violently to the Federal Reserve’s tapering of quantitative easing policy. It lost 10.05 percent then.
As a final note, it’s clear that duration is and continues to be one of the major drivers in the performance of fixed-income ETFs. It is also a double-edged sword that can significantly hurt a fixed-income ETF.
At the time this article was written, the author held no positions in the securities mentioned. Contact Howard Lee at [email protected].