ZROZ: Long-Term Treasury STRIPs ETF, For Dovish Traders (NYSEARCA:ZROZ) (2024)

The Federal Reserve is guiding for three rate cuts this year. Lower Federal Reserve rates should lead to lower interest rates across investment markets. Bond prices could rise, although much will depend on the magnitude and timing of these.

Although I am not personally all that dovish, I am aware of more dovish investors who wish to trade on, and potentially profit from, future rate cuts. For these investors, the PIMCO 25+ Year Zero Coupon U.S. Treasury Index Exchange-Traded Fund ETF (NYSEARCA:ZROZ) might be an interesting choice. ZROZ invests in long-term zero coupon treasury strips, with very long maturities and duration. The fund itself sports a duration of 26.9 years, much higher than average, and higher than that of most long-term treasury index funds. ZROZ should see significant gains from significant reductions in interest rates, making the fund an interesting trading opportunity for more dovish investors.

ZROZ - Basics

• Investment Manager: PIMCO
• Underlying Index: The BofA Merrill Lynch Long Treasury Principal STRIPS IndexSM
• Dividend Yield: 3.52%
• Expense Ratio: 0.15%
• Total Returns CAGR 10Y: 2.90%

ZROZ - Overview and Characteristics

Treasury Strips

ZROZ invests in long-term zero coupon treasury strips, with remaining maturities of at least 25 years. ZROZ's holdings make no coupon or interest rate payments throughout their tenure, and so tend to trade with deeply discounted prices, leading to strong capital gains at maturity.

As treasury strips are something of an obscure asset class, thought to have a closer look or explanation as to how these work. One of ZROZ's holdings is the following strip, data as of late 2023:

Simplifying things a bit, the strip above works as follows.

ZROZ loaned $75M (market value) to the U.S. Government. At maturity, in February 2053, the government will pay ZROZ $235 million (notional/par value) back. There are no interest rate or coupon payments, only a massive payment at maturity. The payment at maturity is significantly greater than the amount loaned, as compensation for the lack of interest rate or coupon payments.

By my calculations, the bond has an IRR, or yield to maturity, of 4.0%, functionally identical to 30Y treasury rates.

Credit Risk

ZROZ invests in treasuries, securities backed by the full faith and credit of the U.S. Federal Government. Credit risk is effectively zero, as are expected default rates, barring an unprecedented U.S. default. Low credit risk significantly reduces losses during downturns and recessions. Due to this, and due to a flight to quality effect and Federal Reserve policy, ZROZ tends to experience significant gains during most traditional downturns and recessions. As an example, ZROZ significantly outperformed during 1Q2020, the onset of the coronavirus pandemic.

Dividend Yields

Securities with low credit risk, including treasuries, tend to sport comparatively low yields.

Securities with longer maturities tend to sport comparatively high yields, due to their increased interest rate risk, and due to tying up investor capital for longer. Right now the opposite is true, with most longer-term bonds yielding less than comparable shorter-term securities. Treasuries themselves show an inverted yield curve.

ZROZ focuses on long-term securities with low credit risk, which should result in very low, below-average yields. ZROZ currently yields 3.5% which, although low on an absolute basis, is higher than that of most bonds and treasuries, with many important exceptions.

ZROZ's dividends are somewhat higher than expected, as the fund's underlying holdings do not actually generate any income, dividends, or coupon payments. I'm not certain why this is the case but believe that the capital gains experienced by the fund get classified as income. I am aware of something similar occurring for TIPs.

Interest Rate Risk and Duration

Some context first.

Interest rates and bond prices are inversely correlated: higher interest rates mean lower bond prices, and vice versa.

The process/explanation of the above is quite simple.

Higher interest rates mean higher yields for newly issued bonds. Older bonds retain their original, lower rates.

When interest rates increase, investors sell their older, lower-yielding bonds to buy newer, higher-yielding alternatives. Selling pressure leads to lower prices for these older, lower-yielding bonds, and capital losses for bond investors.

Although most bonds and bond funds see losses when interest rates rise, the magnitude of these varies. Some see comparatively small losses, some larger.

Shorter-term bonds tend to see below-average losses, as these bonds mature quickly, and so can be quickly replaced with newer, higher-yielding alternatives. Investors in shorter-term bonds might lose out on a couple percentage points worth of dividends for a year or two, but not much else. There is some selling pressure, but not a ton, so prices hold up reasonably well.

The opposite is true for longer-term bonds. These bonds take a long time, upwards of several decades, to mature, and so investors are stuck with weak dividends for decades. Investors might lose out single-digit worth of dividends per year, which add up to double-digit sums in the decades these bonds take to mature. There is a lot of selling pressure, so prices tend to collapse.

Interest rate exposure or risk is generally measured by duration, in years. A security with a duration of 1 year would see 1.0% in losses from every 1.0% increase in rates, with a higher duration meaning higher losses.

ZROZ focuses on long-term zero coupon treasuries, securities with a lot of duration. The fund itself sports a duration of 26.9 years, quite high on an absolute basis, and much higher than that of its peers, including those focusing on more vanilla long-term treasuries.

Due to the above, ZROZ should see significant, above-average losses when interest rates decrease, as has been the case since early 2022.

ZROZ should see gains if long-term rates decrease, as has been the case since the Fed released dovish guidance in late 2023.

ZROZ could see gains if the Federal Reserve were to cut rates, but the situation is somewhat complicated. Long-term treasuries already yield less than shorter-term treasuries and t-bills, as investors anticipate significant rate cuts in the coming years. 30Y treasuries currently yield around 1.3% more than t-bills, for instance.

Right now, investors seem to expect around 2.5% - 3.0% in interest rate cuts in the next few years and are pricing bonds accordingly. Said expectations are based on market surveys by Morningstar, Federal Reserve forecasts, and market prices.

Considering the above, ZROZ is unlikely to see significant gains from smaller, even moderate, rate cuts. Gains are only likely to occur from significant, higher-than-expected cuts. In other words, long-term treasury STRIPs have already seen 30% in gains. I am not certain that further gains are likely.

Investors should strongly consider the impact that expectations, and changes thereof, play in ZROZ's performance. It is simply not the case that lower Fed rates should necessarily lead to higher share prices for the fund. Other factors matter too, and investors are pricing in an aggressive set of rate cuts already. I tried searching for a scenario in which the Fed cut without the fund seeing higher share prices to no avail, but I did find the opposite scenario: the Fed hiked from 2016 to 2019, and ZROZ was flat.

ZROZ should see significant gains if the Fed cuts rates aggressively, but the situation is much more complicated, and more uncertain if the Fed cuts in a more slower, more methodical way.

Conclusion

ZROZ invests in long-term zero-coupon treasury strips, with very long maturities and duration. ZROZ should see significant gains from significant reductions in interest rates, making the fund an interesting trading opportunity for more dovish investors.

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