The year started with overvaluation in the equity market, momentum stock sell-off, geo-political tensions and slowdown in some noteworthy nations like China and Japan (to some extent) which in turn brightened the appeal for safe haven bond assets.
While the U.S. economy is progressing toward the final stage of recovery as evident from the Fed’s steady wrap-up of the QE program, rise in interest rate at some point of time and shortage of cheap dollar to invest in risky assets are inevitable.
In this stage of recovery, the yield curve tends to flatten. With the rising interest rate, corporate profits get squeezed and the flair for bond investing, especially the long-dated ones, returns to the market. Reduced corporate earnings will lead to poorer dividend payout thus hurting investors’ fixed income share in case of equity market investing.
In such a scenario, long-term bond ETFs known for their high yield opportunities should satisfy the craving of yield-hungry investors. Notably, long-term bonds have secured the longest period of gains this year since September 2009.
Why Are Long-Term Bonds Back in the Spotlight?
Across the spectrum of the yield curve, the short-dated bonds remained out of favor since Fed Chair Janet Yellen hinted at hiking short-term interest rates six months after the wrap-up of bond buying program.
Though, of late, the Fed pared down its comments on raising interest rates urgently, most investors and analysts have the impression that short-term rates will be lifted probably mid next year. At the current level, this seems the major driver of the bull run of long-term bonds.
Also, the U.S. economy hardly expanded in Q1 and this lackluster growth should stimulate the appeal for bond investing. Interest rates are also rising slower than earlier feared. The inflationary environment has also been muted, compelling investors not to demand even higher yield to pay costs for inflation risk leading to a rise in long-term bonds (read: Long-Term Treasury Bond ETF Investing 101).
In this backdrop, investors seeking to take advantage of the higher bond prices might try their luck with a long-term bond ETF. While there are a couple of choices in the space, we have highlighted the three ETFs surging the most in the recent past that could be good avenues to park money with higher yields at this time.
25+ Year Zero Coupon U.S. Treasury Index Fund (ZROZ)
This fund targets the Treasury STRIPS market. This product follows the BofA Merrill Lynch Long US Treasury Principal STRIPS index, which focuses on treasury principal STRIPS that has 25 years or more remaining to final maturity.
This means that this benchmark focuses in on fixed income securities that are sold at a discount to face value, and then investors are paid the face value upon maturity. Investors should note that these sorts of bonds which operate on the zero-coupon format can underperform greatly in a rising rate scenario.
ZROZ holds only 21 securities in its basket. Additionally, ZROZ has a bit higher effective maturity – at 27.34 years – while its 30 Day SEC Yield comes in at a slightly more 3.48%.
Still, investors should note that ZROZ is not a very popular option with about $74.1 million in assets, though it does cost just 15 basis points a year in fees. However, with its higher duration and maturity, it can outperform when rates are sliding, as has been the case so far in 2014, allowing ZROZ to log a 19.05% return till date (read: 3 Bond ETFs Surging as Interest Rates Tumble).
Vanguard Extended Duration Treasury ETF (EDV)
For another long-term play on the bond market, investors have EDV, a fund that seeks to match the performance of the Barclays U.S. Treasury STRIPS 20-30 Year Equal Par Bond Index. This particular portfolio has an average maturity of 25.4 years, and a yield to maturity of 3.7% for this 66-holding basket.
Investors should also note that this is a very cheap product, as it charges just 12 basis points a year, so it will be an inexpensive way to get into long duration bonds. EDV has added 1.95% last week and 17.2% year to date (see Best ETF Strategies for 2014).
iShares 20+ Year Treasury Bond (TLT)
This iShares product provides exposure to the long-term Treasury bonds by tracking the Barclays Capital U.S. 20+ Year Treasury Bond Index. It is one of the most popular and liquid ETFs in the bond space having amassed over $3.8 billion in its asset base and more than 7.3 million shares in average daily volume. The expense ratio comes in at 0.15%.
Holding 23 securities in its basket, the fund focuses on the top credit rating bonds (AA+ and higher). The average maturity comes in 27.16 years and the effective duration is 16.81 years. The product gained more than 10.0% year-to-date and 1.12% past week. TLT currently has a Zacks ETF Rank of 3 or Hold rating with a high risk outlook.
In a nutshell, long-term bond ETFs have suffered a lot of wobble last year and are presently trading at a compelling valuation. With the Fed steadily tapering the QE stimulus, investors will now start wondering about the time frame of increases in short-term rates and volatility will remain in the front end of the curve. Thus, long-term bonds can satisfy investors’ need at least for the short term, if not in the long run.
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