I spend a large amount of time researching mutual funds and ETFs for my investment advisory clients and for writing investing stories like the one you’re reading now. But I also periodically run across what I call “outlier funds” with abnormal returns. Whether it be for curiosity or for strategic reasons, investors are wise to dig beneath the surface to understand such outliers.
Well, when I was doing some research on bond ETFs, I came across the Pimco 25+ Year Zero Coupon US Treasury (ZROZ), which has a whopping 30% year-to-date gain.
Naturally, I had to satisfy a few burning questions.
When the broad bond market, as measured by the Barclays Capital U.S. Aggregate Bond Index, is up approximately 5% for the year, why would this this bond ETF be up 35%? What economic or market trend might be behind such an outsized gain? Did the fund manager of ZROZ use derivatives, such as futures, swaps or options, to reach such abnormal returns?
The answers to the questions and the strategies behind this impressive year-to-date gain are simpler than you might imagine.
Understanding the Power of Interest Rate-Sensitive Bond Funds
The returns of a bond ETF or mutual fund are directly impacted by the price of the underlying bond holdings. And the prices of bonds generally move in the opposite direction of interest rates. Also, the longer the maturity, the greater the sensitivity. Therefore, when interest rates fall, long-term bond ETFs and mutual funds will rise in price faster than intermediate- and short-term bond funds.
Getting a bit deeper …
With bond funds, the weighted average maturity of all the cash flows in the portfolio is referred to as “duration,” which is the ultimate gauge for a bond fund’s interest-rate sensitivity. Without getting too complex, a bond fund’s duration is an indication of how it will perform in a changing interest-rate environment. For example, a long-term bond fund with an average duration of 15 years will rise in price by roughly 15% for every 1% that interest rates fall.
The opposite is also true, which is why many market analysts and financial media pundits have been telling investors to move to short-term bond funds for several months, if not for the past few years.
However, interest rates remain low and have even fallen in 2014, which has pushed the price of the average long-term Treasury bond fund higher than the average bond fund. For example, the bond ETF Vanguard Long-Term Government Bond (VGLT) is up 18.5% year-to-date, whereas a broader bond index ETF, iShares Core US Aggregate Bond (AGG), is up 4.9%.
The differentiation in price movement is a direct result of interest-rate sensitivity.
Zero-Coupon Bond Funds — The Ultimate Interest Rate-Sensitive Bond
U.S. Treasury bonds have a sub-category, called Zero-Coupon Bond Funds, which get their name because they pay no interest and the par value is due the investor at maturity. This makes their price more sensitive to interest rates. Therefore, long-term zero-coupon bond funds will have large swings in price in a changing interest rate environment.
The peak-to-trough movement of interest rates in 2014, as measured by the 10-year Treasury yield, is nearly a 1% decline, which explains larger price gains on longer duration bond funds. But the price gains on zero-coupon bond funds are even more pronounced.
One of the best zero-coupon bond ETFs is the aforementioned ZROZ — a dirt-cheap fund (0.15%, or $15 for every $10,00 invested) that’s up an amazing 30% with less than two months to go in the year. This incredible jump in price is a direct function of its average duration of roughly 27 years, plus its added interest-rate sensitivity due to the zero coupon.
Are Zeros a Smart Move Now?
Buying zero-coupon bond ETFs or mutual funds now is essentially a bet that the bond market has incorrectly priced in rising interest rates. The Fed has announced an end to its QE program, but the extension of the low-rate policy beyond 2015 could have a similar effect of lowering rates, which would then push zeros and long-term bond funds higher.
For a bit of a historical perspective, the most recent and significant decline in rates was 2011 and ZROZ had a price gain of more than 60%. Rates did not fluctuate much in 2012, and the price gain for ZROZ was just under 1%. But when rates came back up in 2013, ZROZ fell nearly 21%.
The key takeaway here is that the price volatility for long-term bonds and zero-coupon bond funds can be extreme in rate environments like the current one.
If you haven’t used zeroes in the past, and you decide to steer clear of them now, you at least have a new tool for your diversification chest for the future.
As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.
