The performance of the Pimco 25+ Year Zero Coupon U.S. Treasury ETF (ZROZ) is no stranger to the top-performing ETF list. It was, after all, the highest returning ETF in all of 2011 .
Even more interesting is that ZROZ, a fund with $185 million, more than doubled the performance of the much more widely held $3.76 billion iShares long-term Treasury ETF, the iShares Barclays 20+ Year Treasury Bond Fund (TLT), which is up 37 percent over the past year.
The only other fund that comes close to ZROZ’s performance over the past 12 months is the Vanguard Extended Duration ETF (EDV), which has jumped by two-thirds in the past year.
So is the past prologue? What is the outlook for this red-hot fund and, by extension, Treasurys?
A year ago, conventional wisdom dictated that you’d be crazy to invest in the long end of the Treasury curve, because rates were so low they couldn’t possibly go much lower.
But thanks to heightened global instability and Federal Reserve Chairman Ben Bernanke’s “Operation Twist,” the long end of the Treasury curve did go lower and the “crazies” have been rewarded handsomely. The Fed program involves buying long-dated Treasurys accompanied by its selling of shorter-dated holdings, which together mean the U.S. central bank isn’t enlarging its balance sheet.
ZROZ’s outperformance, relative to TLT, can be attributed to the duration of the fund. Duration is a measure of a fixed-income security’s sensitivity to changes in the interest-rate or inflation outlook—the longer the duration, the more a bond’s price will move as rates shift.
ZROZ has greater duration compared with TLT for two reasons. First, ZROZ is further out on the Treasury curve than TLT, as it selects securities with maturities over 25 years. TLT selects securities with 20 or more years to maturity.
Second, ZROZ selects zero-coupon Treasury securities that don’t make duration-reducing interest payments.
Investors may be wary of ZROZ because of its “phantom income” that results in additional tax liabilities. Zero-coupon Treasury securities are initially issued at a discount to face value. Over time, the discount dwindles and the security appreciates toward its face value.
Some of this appreciation is taxed as income even though no cash on the underlying bonds has been distributed—thus the use of the term “phantom income.” That said, the fund does make a quarterly distribution, while TLT's distributions are monthly.
In comparison, because TLT selects regular long-term Treasurys, investors are taxed on income that they actually receive. That feature may be addding to TLT’s popularity relative to ZROZ.
In any case, ZROZ has benefited immensely from Bernanke’s “Operation Twist,” which suppressed interest rates on the long end of the Treasurys curve.
In an extended period of declining long-term interest rates, one can reasonably expect high-duration securities to outperform. And that’s exactly what’s happened with ZROZ.
By going as far out on the Treasurys curve as possible and by stripping intermittent payments, the fund has nearly maximized its duration and, therefore, interest-rate risk. But in hindsight, interest-rate risk has been minimal over the past year of declining long-term rates.
So, what’s the outlook? One has to wonder how much lower rates can go on long-term Treasurys. The old Wall Street adage “don’t fight the Fed” comes to mind here because the actions of the Federal Reserve will probably have the most profound impact on ZROZ’s future price direction.
For long-term Treasury yields to go lower, there must be more demand for those securities. The most probable source of such demand is either from investors seeking a “safe haven” in an unbearably turbulent and unstable market, or from demand created by purchases of the Federal Reserve.
Basically, for ZROZ to go higher, either the world needs to become a terribly scary place, or “Uncle Ben” needs to step in and take rates lower.
Conversely, much less must happen for long-term Treasury yields to bounce off their record lows.
In other words, anything other than the two scenarios above would likely send yields at least slightly higher and, for a fund with as much duration as ZROZ, even small moves have a big impact.
Ultimately, remember that the Fed is bigger than you, and you don’t want a fight.
ZROZ is maxed out on duration, so small changes in interest rates have a disproportionately large impact on price.
If you have a strong opinion on what the Federal Reserve’s next move is and its impact on the long end of the curve, then ZROZ could be a great way to play.
If not, however, you may want to steer clear to avoid getting stuck on the wrong side of this trade.
At the time the article was written, the author had no positions in the securities mentioned. Contact Spencer Bogart at firstname.lastname@example.org.
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