One Very Risky (But Very Useful) Fixed Income ETF (ZROZ)

A relatively new Bond ETF issued by Pimco called the 25+ Year Zero Coupon Bond

offers some unique advantages for the trader or the investor looking to hedge the equity portion of their portfolio. Pimco's ZROZ is the only ETF of its kind on the market and holds only long dated (25+ year maturity) zero coupon bonds. These bonds of course, as the name implies, issue no coupon payments during the life of the bond, but rather are issued at a steep discount. This means the duration of the bond equals its maturity. So this ETF carries a duration of around 25 years. Roughly speaking this means a 1% move higher in rates will cause a 25% capital loss on this ETF. Yikes! And of course the opposite is also true (as has been the case in 2010). For some investors this ‘leverage' could be ideal for the credit risk free/treasury/hedge portion of a portfolio. If you are looking for an equity hedge, you get a lot more bang for your buck with ZROZ, as opposed to shorter duration bond ETFs like Ishares 7-10 year treasury

or Ishares 1-3 year treasury

. To drive this point home, let's say you had a $100,000 portfolio and were invested 50% in bonds and 50% in equity (each portfolio would hold purely ZROZ, IEF, or SHY as its bond holding). Lets also assume (just to illustrate a point) if rates decreased 1%, signaling economic weakness and slow growth, equities would move down 10%. With all portfolios the equity portion would decrease to $45,000 from $50,000. But let's look at the bond portion. The $50,000 invested in SHY would have increased to $50,500 with its 1 year duration. Not near enough to offset the loss on the equity portion. The $50,000 invested in IEF would have grown to $53,500. This gain matches its 7 year duration. This is much better then SHY, but still not quite a full hedge. But with using ZROZ and its 25 year duration, the original $50,000 is now worth $62,500. This more than offsets the loss on the equities! In essence you're increasing leverage on the fixed income portion of the portfolio which could free up funds for other investments. Of course this is a very volatile ETF and has a lot of interest rate risk associated with it. Anyone considering ZROZ should use extreme caution and probably use it in conjunction with an offsetting asset position. ZROZ is up 25.3% year to date to $85.93/share.