One term that bond ETF investors must be familiar with as it relates to their portfolio is: effective duration. This essential characteristic is what drives one of the key risk and return metrics of all fixed-income. Namely how sensitive your bond fund is to changes in interest rates. The longer the duration of the fund or security, the more volatility it will incur as interest rates fluctuate.
The recent trend of rising interest rates has many bond investors nervous about capital preservation and lowering the volatility of their portfolio. This has created a sizeable exodus from intermediate and long duration securities into shorter-term debt with more minimal price fluctuations. The trade off is that these investors are now subject to smaller monthly income distributions. It also means they have minimized their upside potential in the event that interest rates reverse course once again.
There is an argument to be made that many economic forces are shifting towards a regime change and that short-term bond funds are the safer way to go. Nevertheless, there are likely going to be periods of sharp rallies in bonds that leave openings for tactical allocations to long-duration funds.
One such vehicle is the PIMCO 25+ Year Zero Coupon US Treasury Index ETF (ZROZ). This passive fund has over $150 million dedicated to tracking the BofA Merrill Lynch Long US Treasury Principal STRIPS Index. It doesn’t pay a distribution yield like most bond ETFs. Instead, its holdings include zero coupon U.S. Treasury bonds with maximum maturity dates to capture the long end of the U.S. fixed-income market. With just 20 holdings and an effective duration of 27.28 years, ZROZ is one of the most volatile bond ETFs you can buy.
Of course, that volatility works in both directions. If U.S. Treasury yields were to drop sharply from these multi-year highs, this exchange-traded fund would be one of the top performers in its class.
Those who are worried about the knock-on effects of inflation in the coming years may lean towards Treasury Inflation Protected Securities, or TIPS. The PIMCO 15+ Year US TIPS Index ETF (LTPZ) is an index-based ETF that owns inflation-protected Treasury bonds with an effective duration of 22.10 years. That’s roughly three times the 7.5-year effective duration of the well-known iShares TIPS Bond ETF (TIP), which has over $24 billion under management.
LTPZ is going to have far wider price swings than TIP on a comparative basis. It will also be far more sensitive to the step up of inflationary metrics that would act as a tailwind for this group.
There are also long-duration options available in the investment grade corporate bond sector as well. The iShares 10+ Year Investment Grade Corporate Bond ETF (LLQD) and Vanguard Long-Term Corporate Bond ETF (VCLT) are two solid options for investors to choose from. Both offer exposure to a diverse basket of high quality corporate bonds with a minimum of 10 years until maturity.
LLQD sports an effective duration of 13.68 years, although the weighted average maturity of the bonds in the portfolio are nearly 24 years. The embedded expenses in these funds are quite low as well.
The Bottom Line
Long duration bond funds may seem like a maximum risk proposition in the current interest rate environment. Nevertheless, these tools offer investors liquid and diversified exposure to a subset of the fixed-income market for those who are looking for a retracement in Treasury yields.