A peculiar bond exchange-traded fund (ETF) doubled the returns of the S&P 500 over the last month.
The PIMCO 25 Year Zero Coupon U.S. Treasury Index ETF (NYSE:ZROZ) surged 19.4% from Nov. 1 to Dec. 1, outshining the SPDR S&P 500 ETF Trust (NYSE:SPY), which posted a 9.9% gain.
ZROZ invests primarily in U.S. Treasury bonds with maturities of 25 years or more.
The key characteristic of these bonds is that they are zero-coupon. That means they do not pay periodic interest to bondholders, or ETF holders. Instead, they are issued at a discount to face value and mature at par (face value). For example, a zero-coupon bond trading at 80 cents to the dollar today has a face value of $100 at maturity.
For zero-coupon bonds like those in ZROZ's portfolio, it's key to understand the concept of "duration," also known as the average maturity of the security, which is a measure of a bond's price sensitivity to interest rate changes.
The duration of a zero coupon bond is essentially equal to the bond's time to maturity.
The PIMCO 25 Year Zero Coupon U.S. Treasury Index ETF invests in U.S. Treasury bonds with at least 25 years remaining until maturity, resulting in a duration of at least 25 years.
This long duration means that ZROZ is highly sensitive to changes in the bond's interest rates or yields. A 1% change in the yield of bonds within the portfolio corresponds to an approximate 25% shift in the bond's price.
ZROZ Rallies
ZROZ tends to perform well when interest rates decrease, as the value of its long-term bonds rises.
Conversely, if rates begin to climb, ZROZ could face challenges, given the inverse relationship between bond prices and interest rates.
Over the past month, Treasury yields have fallen substantially, reflecting growing market expectations of Fed rate cuts in 2024
The yield on a 30-year Treasury bond has tumbled from 5.1% to approximately 4.40%, or 70 basis points.
As yields fell, the price of Treasury securities soared. Consequently, duration assets, like long-dated zero-coupon Treasuries, have seen their prices rallying even further.
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