The stock market has melted down over the past few weeks, as investors come to grips with the potential for the coronavirus outbreak to have a lasting impact on economic activity across the globe. Major market benchmarks have already gone through a 10% correction, and some see a bear market as inevitable.
Yet as most stocks have followed the broader market lower, there are a few investments that have been able to post big gains even in the shadow of Covid-19's spread. In particular, ETFs linked to bonds have done extremely well, and the big winner in the bond space has been a little-known fund: PIMCO 25+ Year Zero Coupon Treasury (ZROZ -2.46%).
Why yields are plunging
The bond market has been the safe haven for investors looking for shelter from the rout among stocks. With bonds from many of the largest credit markets in the world offering only negative yields right now -- essentially forcing investors to pay for the right to keep their cash invested in sovereign debt -- the U.S. Treasury market has been one of the sole holdouts in actually paying bondholders to own bonds.
Even before the coronavirus outbreak happened, sluggish levels of economic activity across the globe had sent yields lower. Yet as investors see the potential for a hugely disruptive contraction in the global economy in the months to come, the move downward in bond yields has accelerated. Now, even the U.S. bond market is offering next to nothing in interest for bondholders, with 10-year yields having fallen below 0.75%.
Making the most from bonds
When bond yields fall, the prices of existing bonds rise. That's because the fixed interest payments on existing bonds look more valuable when prevailing interest rates on new bonds fall.
However, different bonds have different levels of sensitivity to interest rates. In general, the longer a bond has until it matures, the more its price will move when bond yields change. Also, the more a bond's repayment is shifted into the future, the greater the price increase will be if yields drop.
That dynamic is why the PIMCO bond ETF has been such a big winner lately. Consider the following facts:
- In just a single month, the ETF's price has jumped more than 25%.
- Year to date, the ETF's return is almost 35%.
- Go back a full year, and the PIMCO bond ETF has soared more than 60%.
That performance stems from the ETF's investment objective, which targets a specific type of investment called a zero coupon bond. Most bonds are structured to make periodic interest payments, typically at semi-annual intervals, in order to give investors some income as they wait for repayment at maturity. However, zero coupon bonds don't pay any interest. Instead, they're sold at a discount to their par value, with investors getting all of their return when the bonds mature. The long-term zero coupon bonds that the PIMCO bond ETF targets are among the most sensitive to changes in yield, explaining how the fund has outperformed nearly every other bond investment.
Playing with fire
It's important to understand that the PIMCO bond ETF can be equally volatile in the other direction. For instance, in the last half of 2016, Treasury yields climbed from around 1.5% to nearly 2.5%. The ETF took a huge hit, falling more than 20% over that period.
For now, though, investors are adjusting their asset allocations, fleeing stocks toward the perceived safety of bonds. Although no one's going to get rich from interest payments of less than 1%, the capital appreciation from bond ETFs like PIMCO 25+ Year Zero-Coupon Treasury will have a lot of people wondering whether they can keep squeezing big gains from the bond market to offset some of their stock losses.