Long duration fixed income exchange traded funds have bee strong performers this year even as the Federal Reserve has boosted interest rates twice. For example,the Vanguard Extended Duration Treasury (NYSEARCA:EDV) is higher by almost 7% year-to-date.
Longer-dated bond funds were seemingly more at risk of a rising rate environment may have been oversold prior to the Federal Reserve’s announcement, which allowed the investments to bounce back once the markets and observers gained a clearer picture on the Fed’s monetary policy.
EDV “follows the Barclays U.S. Treasury STRIPS 20–30 Year Equal Par Bond Index and has an average duration of 25 years, implying hypersensitivity to changes in interest rates. Separate trading of registered interest and principal securities (STRIPS), are bonds that sell at discounts to par value, meaning there are no interest payments,” according to InvestorPlace.
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.
“EDV’s average effective maturity and duration are almost equal to each other – this means that as a simplifying approximation, we will only need yield data for 25-year Treasury STRIPs, since the Macaulay duration of a zero coupon bond is equal to its maturity,” according to a Seeking Alpha analysis of the ETF.
EDV and the rival PIMCO 25+ Year Zero Coupon US Treasury (NYSEArca:ZROZ) are benefiting because longer-dated bonds are more sensitive to hawkish changes in interest rates, meaning the longer the Fed stands pat, the more compelling the higher yields on these ETFs are because rate risk is diminished.
Related: 14 Hedged Bond ETFs for a Rising Rate Environment
Weighing on Treasury yields and bolstering bond prices, the tepid inflation numbers outweighed traders’ concerns over the Fed’s announced quarter-point rate hike and plans to reduce its balance sheet this year.
“The 25Yr STRIP index had a higher rate of return than VFINX, Vanguard’s flagship U.S. stock mutual fund. This is because of steadily falling bond yields during the last 30 years. This will likely not be the case in the future – the Fed is currently seeking to gradually hike the Fed funds rate, which will pressure yields of long-maturity bonds to rise,” according to Seeking Alpha.
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