ZROZ – Moving from Sale to Hold After Decline (NYSEARCA:ZROZ)

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Thesis

At the beginning of April, we wrote an article in which we explained why we were short on the ETF 25+ Year Zero Coupon US Treasury Index ETF (NYSEARCA:ZROZ). In our article, we wrote the following:

We feel the push higher in 30-year rates are not over and we will at least revisit 2018 yield levels. reflected in an additional drop in pure prices of -6%. If you’re a long-running retailer of that name, you’re much better off selling here given that you’re only looking at price drops this year. We will come back once most of the aggressive Fed hikes are over in the fall.

ZROZ is down more than 8% since our article on the back of higher rates. With a very authoritarian Fed convincing the market to aggressively reprice the yield curve upwards, we believe most of the rate move is now behind us. ETF performance is driven by 30-year yields, and we believe most of the movement for this point on the yield curve has already been made. While there may still be room for slippage of up to 3.5%, the aggressive 200 basis point rally seen earlier in the year will not be repeated. So we go from Sale at Hold on ZROZ and pending rate stabilization later in the summer to give the fund a buy signal.

Performance and interest rates

The ETF is down more than 8% since our Sale Evaluation:

performance

Performance (Looking for Alpha)

The fund is down more than 25% based on prices in 2022, representing one of the largest annual declines ever for the ETF:

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Cumulative performance since the beginning of the year (Looking for Alpha)

ZROZ’s move was driven entirely by higher rates this year. 30-year yields are approaching their 2018 highs at 3.43%:

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Rates over 30 years (The Fed)

Earlier in the decade, long-term rates peaked at 3.93%. We believe that we will review the levels of 2018 but not those of 2013. Ultimately, the trend in rates is driven by the Fed and its tightening of financial conditions in order to contain inflation. We believe the market has already done this, and as Goldman Sachs illustrates, financial conditions are on track to reach constrained levels:

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Financial conditions (Goldman Sachs)

With stagnating leading indicators and escalating recessionary talk for 2023, the Fed doesn’t have much wiggle room. In our view, the rate hike is closer to completion than the market is anticipating. The Fed wanted mortgage rates to rise to cool the housing market, and they did. Once they begin to unwind MBS balance sheet holdings, mortgage rates will continue to be constrained.

While corporate balance sheets are healthy and the need to place long-term debt at these higher levels will be moderate over the next few years, rising long-term rates will weigh on new capital projects and investments. It will take a few months for the higher rates to trickle down to the real economy, but in our view, any overshoot of 4% will have a significant impact on the economy.

More market analysts now believe that the bulk of the rate hike is now behind us:

Rates

Rates (Black rock)

With BlackRock and Morgan Stanley in the camp of an implied rate normalization by current market levels, investors should start thinking about reducing short positions in Treasuries.

Assets

The fund is comprised solely of stripped US Treasuries:

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Assets (Annual Report)

STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities, and it basically refers to the fact that the underlying financial instruments have only one payout. We can see that ZROZ holds long-term main strips. Historically, investors looking at Treasury securities have decided that only certain aspects meet some of their needs (i.e. only the interest component or only the principal component) and have decided to strip the Treasury security of origin into underlying cash flows with their own identifiers. Basically, STRIPS allow investors to hold and trade the individual interests and principal components of eligible treasury bills and bonds as separate securities. For example, a 10-year treasury bill consists of a single payment of principal, due at maturity, and 20 interest payments, one every six months over 10 years. When this note is converted to STRIPS format, each of the 20 interest payments and the principal payment become a separate security.

Regardless of the coupon/principal characteristic, STRIPS are always Treasury bills and therefore benefit from the full guarantee of the US government. There is no credit risk in this fund. An investor buying into this name only has to worry about the market risk arising from the fund’s high duration.

Conclusion

There has been no place to hide in long-duration fixed income products in 2022. Down more than 25% this year, ZROZ is bottoming out. Its performance was entirely driven by the rise in 30-year rates, which rose by more than 200 basis points this year. Long-term yields are nearing their 2018 highs, and while there could be more slippage given the Fed balance, itand relaxt is due to start on June 1, we believe most of the rate hike is behind us. So we go from Sale at Hold on the ETF.

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