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Thesis

The U.S. Treasury 25+ Zero Coupon Index ETF (NYSEARCA:ZROZ) is an exchange-traded fund created to mimic the results of the ICE BofAML Long US Treasury Principal STRIPS Index. The fund has a very important duration of 27.66 years which draws its performance. In the current environment of monetary tightening, all discussions currently revolve around the duration and impact of rising rates on each asset class (high duration growth stocks, high yield bonds, etc.) . ZROZ is a clean long play, and as 30-year rates continue to rise, the question arises as to how far the fund’s pricing can go.

ZROZ has always been a strong performer, with 5- and 10-year total returns currently standing at 4.74% and 5.15% respectively. The fund has lost -17% since the beginning of the year, so we have seen a significant attrition of total returns back due to higher rates. A savvy investor with an active management style should recognize that in a tightening monetary environment, a bond portfolio should be skewed towards short-term instruments rather than ZROZ.

We believe the upward push in 30-year yields is not over and we will at least revisit 2018 yield levels. This translates to further tightening of at least 50 basis points, which, for such a high duration fund, results in an additional drop in pure prices of -6%. If you’re a retailer with this long-running name, you’re much better off. Sale here given that you are only looking at disadvantages this year in terms of price. We will come back once most of the aggressive Fed hikes are over in the fall.

Assets

The fund is comprised solely of stripped US Treasuries:

undress

Individual funds (annual report)

STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities, and it basically refers to the fact that the underlying financial instruments have only one payout. We can see that ZROZ holds long-term main strips. Historically, investors looking at Treasury securities have decided that only certain aspects meet some of their needs (i.e. only the interest component or only the principal component) and have decided to strip the Treasury security of origin into underlying cash flows with their own identifiers. Basically, STRIPS allow investors to hold and trade the individual interests and principal components of eligible treasury bills and bonds as separate securities. For example, a 10-year treasury bill consists of a single payment of principal, due at maturity, and 20 interest payments, one every six months over 10 years. When this note is converted to STRIPS format, each of the 20 interest payments and the principal payment become a separate security.

Regardless of the coupon/principal characteristic, STRIPS are always Treasury bills and therefore benefit from the full guarantee of the US government. There is no credit risk in this fund. An investor buying into this name only has to worry about the market risk arising from the fund’s high duration.

Market risk

A long-term chart of 30-year rates gives us a clearer picture of what’s to come:

rates

30-year rate (the Fed)

Until the Covid 2020 crisis, 30-year yields continued to bounce off the 2.5% level, peaking in the last tightening cycle at almost 4%. However, given the substantial increase in the Fed’s balance sheet and quantitative easing over the past 2 years, long-term rates have been at incredibly low levels, having touched 1% during the crisis and currently sits at about 2.63%. We believe 30-year rates will revisit 2018 highs of 3.46% and there is more weakness ahead in the ZROZ price.

IR

IR Sensitivity (Vanguard)

For a long-term fund like ZROZ, we can see that a 1% increase in rates results in a 12% loss in net asset value. Therefore, the further expected tightening of 50 bps will lead to another loss of -6% in net asset value.

Performance

The fund is already down -17% since the start of the year:

YTD

Cumulative performance since the beginning of the year (in search of alpha)

On a long-term chart basis, we can see that in stable or less aggressive tightening environments, the fund tends to hold its value well or even rise on a total return basis:

10 years

10-year total return (seeking alpha)

For example, during the Fed’s tightening cycle from 2013 to 2019, the fund had a positive total return given the extended tightening schedule that allowed the fund’s dividend yield to offset the impact of duration.

Conclusion

ZROZ is an exchange-traded fund that focuses on stripped US Treasuries. With a lifespan of 27.66 years, the vehicle has been hit hard by rising 30-year rates and is down more than -17% year-to-date. We believe the rate hike is not over yet and we will at least revisit the 2018 highs for this point on the curve. This translates into an additional tightening of at least 50 basis points, which for such a high duration fund translates into an additional -6% drop in pure prices. If you’re a retailer with this long-running name, you’re much better off. Sale here given that you are only looking at disadvantages this year in terms of price.