Enticed by high yields, strong performance and perhaps the notion that the Federal Reserve is not as close to raising interest rates as some market observers believe, investors are putting new money to work with zero-coupon Treasury bonds.
Zero-coupon bonds often sell at a sizable discounts to face value because buyers do not get a steady stream of income as they do with traditional bonds. As zero-coupon Treasurys get close to maturity, their value increase with buy-and-hold investors getting the full value of the bond when it matures. [The Scoop on two High-Flying Bond ETFs]
On Friday, “the yield on a 30-year zero-coupon bond was 2.611%, down from 2.8% two months ago, but higher than 2.504% on the regular 30-year Treasury bond. The higher yield is a lure for investors who are confronted with record-low bond yields, some of them negative, in other developed markets. The 30-year German government bond closed on Friday to yield a record low 0.448%, and the 30-year Japanese government bond yielded 1.280%, near a record low,” reports Min Zeng for the Wall Street Journal.
While those yields and impressive performance (zero coupons with maturities longer than 25 years are up nearly 6% this year) are luring investors back to these bonds, zero-coupon ETFs have seen mixed inflows this year.
Investors have added almost $46.3 million to the PIMCO 25+ Year Zero Coupon US Treasury (NYSEArca: ZROZ), but have yanked $39.6 million from the Vanguard Extended Duration Treasury ETF (NYSEArca: EDV).
Because zero-coupons do not deliver regular income, the bonds and ETFs such as ZROZ and EDV are vulnerable to increase in short-term interest rates. 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]
When Treasury yields plunged last year, EDV and ZROZ fought for top honors among non-leveraged bond ETFs with ZROZ winning with a 48.7% 2014 gain. EDV, the Vanguard offering, rose 44.7%. That average gain of 46.7% easily trumped the 27.3% returned last year by the iShares 20+ Year Treasury Bond ETF (NYSEArca: TLT).
Since the start of April, investors have pulled nearly $13 million from EDV while adding $6.4 million to ZROZ.
“Zeros are a small slice of the $12.6 trillion U.S. government bond market. At the end of March, the total outstanding value of zero-coupon Treasury bonds stood at $212.billion, up from $204.7 billion at the end of 2013,” according to the Journal.
PIMCO 25+ Year Zero Coupon US Treasury Index ETF
Tom Lydon’s clients own shares of TLT.