Fixed income exchange traded funds with exposure to the long end of the Treasury yield curve are loving this year’s 23% decline in 10-year Treasury yields.
Two such ETFs, the PIMCO 25+ Year Zero Coupon US Treasury (NYSEArca: ZROZ) and the Vanguard Extended Duration Treasury ETF (NYSEArca: EDV), are 34.3% an 31.6% year-to-date, respectively, according to ETF Replay data.
To put the potency of those performances into context this, consider the following: Only five non-leveraged ETFs have outperformed EDV this year. ZROZ is one. The other four track volatile asset classes such as coffee futures, Indian small-caps and biotechnology stocks. [A Stellar PIMCO ETF]
Although Treasuries are not often thought of as a volatile asset class, EDV and ZROZ are proof positive that there is no such thing as a free lunch in financial markets. The “secret” behind the price appreciation of these ETFs is also their primary risk.
EDV and ZROZ hold Treasuries where the coupon has been stripped out. Here is the skinny on that situation: “These denuded bonds sell at a big discount to face value at first, because buyers don’t get those regular interest payments. A 30-year Treasury with a face value of $1,000, for example, sells for just $470. As the bond gets closer to its maturity date, its value rises. At maturity, buy-and-hold investors get the full face value of the bond,” reports Eric Balchunas for Bloomberg.
Translation: These ETFs are extremely sensitive to interest rate fluctuations due to durations north of 27 years for ZROZ and 24.9 years for EDV. EDV and ZROZ have already shown investors the risks of stripped coupons in rising rate environments. When Treasury yields spiked last year, EDV and ZROZ lost an average of 20.5%. [Long Duration ETFs Will Suffer if Rates Rise]