Top Performing Bond ETFs Pay No Income
Zero-coupon bond funds are all about price appreciation, or depreciation.
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.
Declining Rates A Boon
In the past three years, the 30-year STRIPS yield fell from 3.57% to 2.65%. That's been a boon for ZROZ, which holds STRIPS with maturities of 25+ years; and EDV, which holds maturities of 20 to 30 years.
30-Year Treasury STRIPS Yield
The vast majority of the increase in the two ETFs during the last three years has come from changes in interest rates rather than yield. ZROZ and EDV both have SEC yields in the 2.5% range (though their underlying bonds don't make coupon payments, the ETFs make distributions with proceeds from bond sales at rebalance).
Indeed, about three-quarters of the funds' 40%-plus three-year returns came from declining rates.
For ZROZ and EDV to continue to perform as well as they have, interest rates will need to take another leg lower. On the other hand, if long-term rates rise, they will be among the hardest-hit fixed-income ETFs.
Calculating Interest Rate Sensitivity
To see how much these ETFs will move from interest rate fluctuations, investors can use a number called "modified duration," which measures the sensitivity of a bond or bond portfolio to changes in rates.
For zero-coupon bond ETFs, the duration figure is close to the weighted average maturity of the underlying bonds. For ZROZ, it's around 27; for EDV, it's around 25.
That means that a 1% increase in interest rates will lead to a 27% decrease in the value of ZROZ, while a 1% decrease in interest rates will lead to a 27% increase in that ETF.
Duration is most accurate for small changes in interest rates because the relationship between bond prices and yields is not linear. Duration will tend to underestimate bond price increases when rates fall, and overestimate bond price declines when rates rise.
Nevertheless, it's a good number to keep on hand for quick calculations on bond ETF interest-rate sensitivity. The duration figure can be found on the ETF.com fund pages or issuer websites.
For investors willing to make a strong bet on rates, ZROZ and EDV are two of the best ETF products to do so. Just be ready for wild, double-digit swings in the ETFs when interest rates make their move.
Contact Sumit Roy at [email protected].
