Being Wrong on Long Bonds Cost Buyers Up to 30% This Year

The trade everyone loved to hate in 2013 is this year’s biggest winner: long bonds.

Who knew buying these assets would be the way to go as the Federal Reserve cuts back on its debt purchases? Two exchange-traded funds managed by Pacific Investment Management Co. and Vanguard Group Inc. have returned about seven times the average gains for hedge funds focusing on fixed income by buying baskets of zero-coupon Treasuries that mature in more than 20 years. Pimco’s strategy has reaped 17 percent this year.

Investors that borrowed money to juice up that trade, like an ETF run by Direxion, made as much as 30.6 percent through yesterday. That’s the best performing fixed-income ETF this year, according to data compiled by Bloomberg.

Last year’s concern that interest rates would rise sent buyers into shorter-term debt, which has resulted in meager gains in 2014. Treasuries maturing in one year to three years have returned 0.2 percent this year, Bank of America Merrill Lynch index data show. Now, investors are capitulating to the idea that rates may stay low for much longer.

Bank of America Corp. strategists, who last year heralded a great rotation out of bonds and into stocks, are now talking about a “rotation back into duration,” or debt that’s more sensitive to moves in interest rates.

Individual investors are taking note they’re missing out. They yanked money from short-term, high-grade debt funds last week for the first time since 2011, and accelerated their deposits into longer-term investment-grade bonds, Bank of America analysts Hans Mikkelsen, Yuriy Shchuchinov and Ralf Preusser said in an April 21 report.

Sensitive Debt

This year’s performance is a reversal of 2013’s, when the longest-maturity bonds fared the worst. Zero-coupon Treasuries - - which don’t make regular interest payments -- plunged 21.8 percent in 2013, the Bank of America Merrill Lynch Long U.S. Treasury Principal STRIPS Index shows.

The debt is more sensitive to moves in interest rates than most other bonds and tumbled as the Fed prepared to curtail its monthly securities purchases. The economy was doing better, and yields seemed poised to rise.

Consensus expectations have been turned upside down by an economy that slowed and Fed policy makers who have pushed back the outlook for when they’ll start boosting borrowing costs. The central bank has kept its benchmark lending rate near zero since the end of 2008.

Worst Trade

Zero-coupon Treasuries with longer maturities are returning 17.4 percent this year, the Bank of America Merrill Lynch index data show. That compares to average returns of 2.33 percent for relative-value debt hedge funds, according to Hedge Fund Research Inc. data.

Pimco’s $74.3 million 25+ Year Zero Coupon U.S. Treasury index ETF has gained 17.2 percent this year, almost making up for its 20.9 percent loss last year. Vanguard’s Extended Duration Treasury $201.5 million fund has returned 15.6 percent in 2014. Those two are the best-performing fixed-income ETFs that don’t rely on leverage, according to data compiled by Bloomberg.

Whether these funds will continue to be winners remains to be seen. At some point, the Fed will wean the world’s biggest economy from its easy-money policies, probably sending bond yields up.

For now, their investors are enjoying the rewards of putting their money in one of last year’s worst trades.

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