Earlier this week, an article on ETF.com took a look at four strong-performing areas of the fixed-income universe. Those areas―"fallen angel" junk bonds, dollar-denominated emerging market debt, preferred stocks, and high-yield municipal bonds―all offered high, sustainable yields.
On a total return basis, ETFs tied to those areas were among the best-performing fixed-income ETFs in the last few years. However, they weren't the No. 1 performers in the segment.
That title belongs to a pair of products tied to bonds that offer no regular income at all: zero-coupon bonds.
What Are Zero-Coupon Bonds?
Zero-coupon bonds are bonds that are sold at a discount to their face value and do not make any periodic interest payments. Investors get their money back—including interest—in a lump-sum payment when the bonds mature. Because they don't make any coupon payments in the period before they mature, these are known as "zero-coupon bonds."
They are much more interest rate sensitive than their ordinary bond counterparts―no matter what maturity we're talking about. A two-year zero-coupon bond is much more rate sensitive than a two-year bond that makes coupon payments. The same goes for five- or 10-year bonds.
The reason for the higher sensitivity is you’re getting paid back further out in time. With traditional bonds, you're getting paid earlier with the periodic coupon payments. So if rates spike, the present value of your future cash flows decreases significantly.
ZROZ & EDV Surged In Last 3 Years
The PIMCO 25+ Year Zero Coupon US Treasury Index ETF (ZROZ | C-57) and the Vanguard Extended Duration Treasury Index Fund (EDV | B-50) are the two ETFs that hold zero-coupon Treasurys, also known as STRIPS, which stands for “separate trading of registered interest and principal of securities.”
ZROZ and EDV are the best-performing fixed-income ETFs of the past three years, with returns of 42.5% and 40.4%, respectively.
3-Year Returns For ZROZ, EDV
Not only do the funds hold STRIPS, they hold some of the longest-dated bonds on the market. Long-dated bonds in general are already extremely rate sensitive, but long-dated STRIPS are the most interest-rate-sensitive bonds of all.
That means that when interest rates fall, ZROZ and EDV are the biggest beneficiaries (interest rates and bond prices move inversely). Of course, the opposite holds true: If rates rise, these ETFs will be the hardest hit.