On the back of a 42% drop for 10-year Treasury yields, 2014 was an excellent year for fixed income exchange traded funds.
Inflows to bond ETFs hit a record in 2014 as the iShares Core U.S. Aggregate Bond ETF (NYSEArca: AGG) and the Vanguard Total Bond Market ETF (NYSEArca: BND) ranked among the top 10 asset-gathering ETFs.
Based on returns, the PIMCO 25+ Year Zero Coupon US Treasury (NYSEArca: ZROZ) and the Vanguard Extended Duration Treasury ETF (NYSEArca: EDV) were the best fixed income ETFs in 2014, returning an average of 46.7%, good enough to place both among the top 10 non-leveraged ETFs of any stripe. [A Stellar PIMCO ETF]
Although the release of FOMC minutes Wednesday showed the Federal Reserve remains committed to raising interest rates later this year, ZROZ hit an all-time high while EDV touched its highest levels in six years. The reason for the success of EDV and ZROZ even as many market observers are forecasting higher interest rates is simple: As the ETFs’ names imply, these are longer duration funds, meaning they are more sensitive to changes in long-term interest rates. If and when the Fed finally raises rates, it will most likely be short-term rates.
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 in 2013, EDV and ZROZ lost an average of 20.5%. [Long Duration ETFs Will Suffer if Rates Rise]
Judging by the price action by and inflows to ZROZ and EDV, investors are not yet concerned about long-term rates moving higher. ZROZ and EDV are up 14.3% and 12.5%, respectively this year. The pair have taken in about $91 million combined in new assets.
ZROZ and EDV, like nearly every other investment, are not free lunches. Long-term interest rates have only resided at current levels once before, from 1934 to 1956.
Additionally, if the Fed proceeds with raising short-term rates without doing the same to long-term rates, the yield curve could become inverted, a condition that is often a precursor to a recession.
PIMCO 25+ Year Zero Coupon US Treasury ETF