ZROZ: Direct Exposure To Interest Rate Policy Through Ultra-Long Treasury Bonds

The PIMCO 25+ Year Zero Coupon US Treasury Index ETF (ZROZ) is a passively managed exchange-traded fund designed to provide exposure to ultra-long-term US Treasuries. With exposure to zero-coupon Treasuries, the strategy will provide pure exposure to the long end of the yield curve with significant exposure to duration risk. Given ZROZ’s direct exposure to duration risk, the ETF may be most suitable for those expecting cuts to the key interest rate or a yield curve inversion. Additional risks to consider for ZROZ include the expected rate of inflation and future interest rate policy, as well as the monetary supply and demand for long-duration US Treasuries.

About PIMCO 25+ Year Zero Coupon US Treasury Index ETF

ZROZ was launched by PIMCO on October 30, 2009. The ETF has a gross expense ratio of 15 bps, on par with peer strategies on the market.

ZROZ has approximately $1.66 billion in assets under management with an average of $46 million in share value changing hands on a daily basis at the time of writing, exhibiting substantial liquidity for active investors. The fund has a narrow 30-day average bid/ask spread of 0.07%, facilitating low round-trip costs.

The ETF pays out a quarterly dividend that fluctuates based on the interest rate cycle and demand for long-term Treasury bonds. ZROZ paid out $3.25/share over the last twelve months for a yield of 5.56%.

ZROZ was designed to track the ICE BofA Long US Treasury Principal STRIPS Index, aiming to match the average duration rate. The Index is comprised of Separate Trading of Registered Interest and Principal of Securities, which represents the final principal payment of the US Treasuries. The Index only provides exposure to STRIPS that have at least 25 years remaining to final maturity and are stripped from US Treasuries that have at least $1 billion in outstanding face value. The Index rebalances quarterly, dropping securities that no longer qualify under the required criteria in the following quarter.

Investor Suitability

ZROZ can be utilized by macro investors seeking to capitalize on long-duration risk. Given that ZROZ does not provide dynamic, active management, as well as the high duration risk, the ETF may not be appropriate for long-term, passive investors.

ZROZ has an effective duration rate of 27 years, making the strategy extremely sensitive to changes in the key interest rate. For example, if the Federal Reserve were to raise the Federal Funds rate by 1%, ZROZ can be expected to lose 27% of its value. Given the high duration risk, ZROZ may be most suitable when an investor anticipates a rate easing cycle. For those seeking a more passive approach for fixed income, an actively managed ETF or closed-end fund may be more suitable.

Risks Related To ZROZ

ZROZ was designed to provide exposure to the ultra-long end of the yield curve, presenting investors with certain risks that should be considered before making a final investment decision. ZROZ exhibits significant duration risk with an effective duration of 27 years, making the fund extremely sensitive to changes in the base rate. The fund’s performance may be influenced by various factors tied to the long-term economic outlook and the expected rate of inflation, both of which may influence the Federal Reserve’s interest rate policy decisions as well as the yields across the broader bond market.

If the market expects that the Federal Reserve will undergo a series of rate hikes, ZROZ may significantly underperform shorter-duration bond funds. A higher expected rate of inflation may also negatively impact ZROZ as investors may seek a higher yield given the deterioration of the value of the underlying currency. Investors may use the FedWatch tool offered by CME to monitor the market’s expectations for future interest rate policy.

The value of ZROZ may also be influenced by foreign demand for US Treasuries. US Treasuries have traditionally been held as reserve currency amongst foreign central banks. If international demand for long-duration US Treasuries were to diminish, ZROZ may face weaker performance.

Final Thoughts

ZROZ provides direct exposure to the underlying yield curve, providing price performance based on interest rate policy, inflation expectations, and market demand for Treasuries. Investors must weigh the broader macroeconomic outlook when evaluating the timing for an investment in ZROZ, as the fund exhibits exceptionally high duration risk.

This article answers three questions about ZROZ:

1. What objective does ZROZ have, and how does it aim to achieve it?
2. What risks pertain to ZROZ?
3. Which investors is ZROZ suitable for?

Editor’s note: This article is intended to provide a general overview of the ETF for educational purposes only and, unlike other articles on Seeking Alpha, does not offer an investment opinion about the ETF.