3 Bond ETFs Surging As Interest Rates Tumble [iShares Barclays 20+ Yr Treas.Bond (ETF), Vanguard Extended Duration ETF]

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February 7, 2014 5:21pm NYSE:EDV NYSE:TLT

etfsThanks to fears over the taper’s impact on the bond markets, interest rates were slowing rising going into 2014. In fact, rates on the benchmark 10-year government bond hit 3% to start the year, leading many to fear that an interest rate spike was on the horizon.

However, this hasn’t materialized at all, and instead interest rates have actually plummeted even with the lower Fed bond buying. The culprits for this reversal have been ongoing weakness in emerging markets and U.S. stock volatility, two factors which are driving investors around the world back into fixed income securities, helping to send rates sharply lower.

Benchmark government debt has actually seen interest rates fall down to the 2.7% mark, a decline of 30 basis points in just over a month. And with ongoing concerns over the market’s direction and the health of emerging markets, it looks like bond rates could stay subdued in the near term, no matter what the Fed decides to do for the taper.

Given this change in perception, some securities in the bond ETF world, many of which were among 2013’s biggest losers, have seen new life in 2014. They have actually also been top performers to start this year, and with their solid yields, could be interesting selections for investors who believe that lower rates are here to stay for a little longer.

Below, we highlight three of these products which have seen strong YTD gains and are really benefiting from the tumbling yields across the market. Any of these funds could be interesting selections for investors who believe that bond prices will continue to strengthen and that safety will continue to be the name of the game in the near term:

iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT)

This product is one of the more popular long-term Treasury bond ETFs on the market, possessing close to $3.2 billion in AUM. Volume is also exceptional, as more than eight million shares usually change hands on a daily basis.

The product looks to the long end of the curve for its exposure, tracking the Barclays 20+ Year Treasury Bond Index for exposure. With this focus, the fund charges just 15 basis points a year in fees, and has a weighted average maturity of 27.3 years ensuring ultra-long term bonds are the main target of this product.

This has been a winning strategy thanks to plunging rates across the curve, as this fund has added close to 6.5% so far in 2014. And with a 30-Day SEC Yield of 3.5%, the product remains a solid income destination as well.

Vanguard Extended Duration Treasury ETF (NYSEARCA: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 means that this benchmark zeroes in on fixed income securities that are sold at a discount to face value, and then the investor is paid the face value upon maturity.

As such, these bonds are usually very sensitive to interest rate changes, and can be greatly impacted by shifting rates. This particular portfolio has an average maturity of 25.3 years, and a yield to maturity of 4.1% for this 65 bond 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 a very low cost way to get into long duration bonds. However, the real selling point as of late has been the price appreciation as EDV has added roughly 9.9% in the year-to-date time frame (see Best ETF Strategies for 2014).

PIMCO 25+ Year Zero Coupon US Treasury Index Fund (NYSEARCA:ZROZ)

Another fund targeting the Treasury STRIPS market is ZROZ. This product follows the BofA Merrill Lynch Long US Treasury Principal STRIPS index, which focuses on treasury principal STRIPS that have 25 years or more remaining to final maturity.

This results in a portfolio that is similar to EDV, though ZROZ only holds 21 securities in its basket. Additionally, ZROZ has a bit higher effective maturity—at 27.3 years—while its 30 Day SEC Yield comes in at a slightly more robust 3.65%.

Still, investors should note that ZROZ has less in volume and assets, while it does cost 15 basis points a year in fees. However, with its higher duration and maturity, it can outperform when rates are sliding, which has been the case in 2014, allowing ZROZ to post a 10.5% gain YTD.

Bottom Line

Just remember that all of these bond ETFs have very uncertain long term outlooks, and could eventually be hit by the taper. This may be especially true if emerging market rate hikes start to stem the flow of capital out of these nations, and if U.S. stocks can resume their upward trajectory.

Until that time though, the aforementioned bond ETFs look to remain in focus. They are primed to be the biggest beneficiaries of the downward move in rates, and with their solid yields they can help your portfolio to absorb some of the recent market shocks in the mean time as well.

This article is brought to you courtesy of Eric Dutram.

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