The Best Bond ETF Of 2014

With just a handful of trading days left in 2014, the race for the best performing fixed-income ETF of the year has virtually been decided.

The interest rate environment this year has been one of persistent decline that has defied the odds of economists and central bankers that had feared higher Treasury yields.  The biggest beneficiaries of this decline have been on the long end of the yield curve, which is currently sitting near its lowest levels of 2014.  

The ETF that was able to most successfully capture this sharp drop in interest rates is the PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ).  So far this year, ZROZ has gained a whopping 48 percent in total return.

ZROZ has benefitted from having the highest effective duration of any ETF in the marketplace at 29 years.  This makes it extremely sensitive to long-term interest rate fluctuations.  In effect, ZROZ is a pure directional bet on a falling interest rate environment.
 

The high sensitivity to interest rates may be one reason why this fund has a very understated asset total of just $92 million.  ZROZ has just 21 underlying holdings, a 30-day SEC yield of 2.78 percent, and a low expense ratio of 0.15 percent.  

However, its returns have far exceeded a broad-based basket of fixed-income in the iShares Total Bond Market ETF (AGG).  This total bond ETF has gained just 6 percent in 2014.  AGG invests in a  wide spectrum of treasury, mortgage, and investment-grade corporate bonds with an overall effective duration of 5 years.  

Runner up in the fixed-income category for 2014 is the Vanguard Extended Duration Treasury ETF (EDV), which has posted a gain of over 44 percent.  EDV implements a similar portfolio of ultra-long duration zero-coupon Treasury securities with an average maturity of 25 years.  

While these ETFs set the bond world on fire in 2014, it remains to be seen whether a potential Fed rate hike next year will negatively impact these holdings.  A new year will bring fresh opportunities and risks for fixed-income investors to navigate.