ZROZ PIMCO 25 Plus Yr Zero Coupon US Treasury Index ETF

Perceived as one of the safest investment avenues across the globe, U.S. Treasuries (especially the long dated ones) have witnessed a significant rally in the past one year, mainly thanks to the Eurozone debt crisis and a generic slowdown in most parts of the world. This has led to a sharp increase in volatility in the equity markets across the board and caused investors to shift to ‘flight to safety’ mode (read 3 Safe Havens to Weather the Storm).

The sovereign debt securities of the world’s largest economy have always been the ultimate safe haven investment avenue and many a time have come to the rescue of the distressed investors during times of acute global economic turbulence. Be it the 2008 sub-prime mortgage crisis or the 2010-11 Eurozone debt crisis, investors have often showed their confidence and belief in the U.S Treasury market for safety and stability (for reference see the table 1).

However, investors should also note that, when the brief risk aversion climate among investors is over, and the focus is back on riskier asset classes such as equities, the yields on these instruments tend to increase causing prices of these bonds to fall. As a result investors are almost certain to lose their parked money in these instruments, especially when inflation is greater than the yield (as it is now).

Many a times the Treasury Bonds are termed as ‘risk free.’ However, this term should not be viewed upon in isolation and it is very important to note the context in which this term is used. Economists/analysts who refer to Treasuries as risk free merely address these instruments from a credit (counterparty) risk point of view. After all, the sovereign is considered to be a good borrower and expected to honor all of its payment obligations in full (read How Low Can Yields Go?).

However, taking a look at the other side of the picture is equally important. Since these instruments are publicly traded in the market place they have a bit of interest rate risk present in them. These risks/reward tradeoffs are higher as we move higher up the yield curve (see Three Impressive Small Cap Dividend ETFs).

The table below would support the above point. The table summarizes the returns of various long dated Treasury bond ETFs across various time horizons 1) Year to Date Returns, 2) One Year Returns as of 31^st July 2012 and 3) 2008 returns (during the sub prime mortgage crisis) across various duration levels. (Duration measures the interest rate sensitivity of a bond with higher duration implying more sensitivity).

Table 1

 

ETF	Year Till Date  Returns (as on 29th August 2012)	1 Year Returns (as on 31st July 2012)	2008 Returns	Average Maturity (years)	Avg. Duration (years)	Yield	Exp Ratio	AUM
TLO	4.95%	30.76%	23.93%	23.94	16.45	2.62%	0.13%	$58.07 million
VGLT	5.09%	32.51%	N.A	24.00	16.48	2.80%	0.14%	$73.98 million
TLT	4.99%	36.63%	33.95%	27.72	17.23	2.50%	0.15%	$3.50 billion
EDV	6.39%	63.89%	54.21%	24.70	26.30	2.65%	0.13%	$205.42 million
ZROZ	6.06%	69.39%	N.A	29.88	29.88	2.61%	0.15%	$104.98 million

Two things are noteworthy from the above table. First, as we climb up the duration ladder the returns tend to improve in a lowering yield scenario. Second, it is also worth pointing out that these long dated securities serve as the ultimate safe haven during times of global economic uncertainties which is demonstrated by the fact that these bond ETFs have generated abnormally high returns during the uncertain economic situation in 2008 and 2011-12. (N.A applies to ETFs which were launched after 2008).

Of course, other factors (apart from the safe haven scenario) have also contributed behind the low yields for these Treasury bonds. The Federal Reserve’s ultra low yield policy in order to strike a balance between growth and inflation and the extension of ‘Operation Twist’ in order to decrease long term borrowing costs and boost growth, have also gone a long way in reducing yields.

Quantitative Easing III and its Implication on Bond ETFs

While a lot of discussion and research has been done in order to gauge the impact of another round of bond buying by the Central Bank (also known as Quantitative Easing 3), just before the Jackson Hole meeting on Friday, however, here we would like to highlight the impact of a possible QE3 (or not) on these long dated bond ETFs (see Will Jackson Hole Be A Non Event?).

If QE 3 does take place, the yields on the longer dates securities will likely fall further (since the Central bank cannot act on the shorter end of the yield curve as these short dated bonds are sporting almost 0% yields) thereby causing further appreciation in the prices of these bonds and their corresponding ETFs.

However, if the possibility of QE3 is completely written off, the present policy is likely here to stay for a while, keeping rates low while giving long term bond ETFs a decided advantage on a yield front. Therefore, we see that either way, the biggest beneficiaries will be the bonds sitting at the longer end of the yield curve.

In light of this, we have highlighted some of the many options in the long end of the U.S. Treasury curve that could make for great choices for investors in this QE3 climate. We think that they could be well poised no matter what happens in Jackson Hole or later this year, making any of the following ETFs worth considering for yield starved or bond light ETF investors:

SPDR Barclays Capital Long Term Treasury ETF (TLO) was launched in May of 2007. The ETF has total assets of $57.87 million and an average daily volume of 20,433 shares. It tracks the Barclays Capital Long U.S. Treasury Index which measures the performance of U.S Dollar denominated Treasury bonds having a residual maturity of 10 years or more (read The Guide to International Treasury Bond ETF Investing).

The ETF has an average duration of 16.45 years and has a distribution yield of 2.62%. The fund has returned 30.76% in the last one year period as of 31^st July 2012 and charges investor’s 13 basis points in fees and expenses compared to a category average of 0.15%. TLO holds 39 securities in its portfolio allocating almost half of its total assets in the top 10 holdings.

Vanguard Long Term Government Bond ETF (VGLT) tracks the price and yield performance of the Barclays Capital U.S. Long Government Float Adjusted Bond Index. The index measures the performance of U.S Treasury securities having a maturity of 10 years or more. The benchmark holds 87 securities in all, however, the ETF tracks the performance of 60 such securities which best represent the index.

VGLT has an average duration of 16.48 years and has returned 32.51% in the last one year period as on 31^st July 2012. The ETF pays out 2.80% as yields and charges investors 0.14% in fees and expenses.

The Vanguard product has attracted a good amount of inflows in its asset base in the last one year. As of 29^th August 2012 its total assets stands at $73.98 million.

iShares Barclays 20+ Year Treasury Bond ETF (TLT) and the Vanguard Extended Duration Treasury ETF (EDV) are two products which measure the performance of U.S Treasury securities having a residual maturity of 20 years or more. TLT tracks the Barclays U.S. 20+ Year Treasury Bond Index, whereas EDV tracks the Barclays Capital U.S. Treasury STRIPS 20-30 Year Equal Par Bond Index.

Although the objective of these two ETFs is quite similar, both of these products employ different methodologies to achieve the underlying objective.

TLT can be thought of as a ‘plain vanilla’ treasury bond ETF which targets the long end of the yield curve. It holds 20 securities in its portfolio and is the biggest and most popular ETFs from the list of discussed ETFs. It has a huge asset base of $3.50 billion and an average daily volume of 8.4 million shares.

TLT has an annual distribution yield of 2.50% and has an expense ratio of 15 basis points (see Escape Low Yields with These Three Bond ETFs). TLT has an average residual maturity of 27.72 years and an average duration of 17.23 years.

On the other hand, EDV offers a STRIPS play on the treasury bond market instead. This means that the interest payments and principal repayments are made independent of each other and are treated as separate components (see Convertible Bond ETFs for Income With Growth Potential).

The ETF has had a fantastic run in the past one year returning 63.89% in the previous 52 week period as of 31^st July 2012. EDV targets the longest maturity bucket in the treasury yield curve and although it is pretty similar to EDV, it has an average duration of 26.30 years which is significantly higher than that of TLT.

EDV charges an expense ratio of 13 basis points compared to a category average of 0.15%. The ETF holds only 54 securities in its portfolio and was launched in December of 2007. EDV has an asset base of $205.42 million and an average daily volume of 35,413 shares.

Like EDV, PIMCO 25+ Year Zero Coupon U.S. Treasury ETF (ZROZ) also provides a STRIPS play on the longer end of the Treasury yield curve. Since the ETF can be thought of as a portfolio of a zero coupon bonds (due to the STRIPS technique) its average duration and average residual maturity is equal at 29.88 years.

It targets the longest end of the yield curve, however, pays out 2.61% in yields which is superior to many similar zero coupon securities out there (see Comprehensive Guide to Money Market ETFs).

The total portfolio consists of 17 securities and the fund was launched in November of 2009. Since then, it has attracted an asset base of $104.98 million. The ETF charges 15 basis points in fees and expenses and has an average daily volume of 43,271 shares.

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VANGD-EX DUR TR (EDV): ETF Research Reports
 
SPDR-BC LT TRS (TLO): ETF Research Reports
 
ISHARS-BR 20+ (TLT): ETF Research Reports
 
VANGD-LT GOV BD (VGLT): ETF Research Reports
 
PIMCO-25Y ZERO (ZROZ): ETF Research Reports
 
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