Poor returns, high volatility, minimal yield given the risk…why would anyone in 2022 want to include Extended Duration Bond funds in a portfolio? They are awful right now, no doubt about that, but nevertheless, extended duration bonds funds like EDV can play an important role in a RP portfolio.
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The Basics:
Although often viewed as a “safe” asset, bonds too can be risky and face price declines when interest rates are raised. Setting aside the possibility that the borrower might default, which we can do with US government bonds, the longer dated the bond, the riskier. This is explained by “duration” which means the price sensitivity of a bond to changes in interest rates. With 20 year Treasury bonds, an interest rate increase the next year after the bond was issued would result in a huge price decline for the one-year old bond, as it looks like it might have 19 more years of “low” payments compared to the just issued bond. A 5 year bond has the same problem, but not for as long, meaning it has less sensitivity than a 1 year debt, and so on.
Meanwhile, we have these things called “extended duration” bond funds which basically invest in 30 year bonds and sell them within a few years of purchase, thereby keeping the effective duration close to 30 years. The result is a fund made up of the bonds most sensitive to price swings, and this year, those swings have been decidedly down. For example, Vanguard’s version of this strategy (EDV) is down 20% over the past three months. As inflation looks like it won’t be reversing any time soon, there isn’t much optimism on the horizon, either.
Extended duration bond funds track the index for STRIPS, or “Separate Trading of Registered Interest and Principal of Securities,” also known as “Zero Coupon Bonds” as the coupon payments are separated from the principal repayment at the end of the term, with all parts traded on their own.
By “extended duration,” we mean these bonds with longer timeframes, usually 30 years, and then re-sold within five to ten years, with the money used to buy more of those 30 year STRIPS and so on. This makes the average duration of EDV 24.4, or in other words, VERY sensitive to rate changes. It isn’t unheard of these to move 5% in a day.
So why on earth would anyone want this asset? In short, because it's great at capturing interest rate risk and can counterbalance the equities in your portfolio. Typically, EDV is the fixed income asset most negatively correlated with equities, making this the best “zagger” when the equities in your portfolio are “zigging.” Think of them a bit like Long-term Treasuries, only more so:
Fair disclosure: the negative correlation between EDV (or Long-term Treasuries) and equities hasn’t been true lately. In difficult, or at least chaotic, economic times, we can usually expect a “flight to safety” as people leave the stock market and seek the safety of Treasuries, where at least you’ll make something.
These days, with inflation the headline, this hasn’t worked quite as well as people ask why they should lock up their money at 3 or 4% interest while inflation runs at 7 or 8%. In times of inflation, the oppositional relationship doesn’t tend to hold (and commodities seem to be the only asset class to benefit).
As for Vanguard’s EDV specifically, I use it mostly just because I defer to Vanguard’s ETFs when given a choice, mostly due to lower expense ratios and a commitment to keeping them low and lowering when possible. EDV’s expense ratio is just .06%, compared to .15% for the PIMCO version (ZROZ) and the iShares version (GOVZ).
Correlation with Other Assets:
Link for matrix on Portfolio Visualizer
The matrix below shows EDV’s slight edge in negative correlation to stocks compared with VGLT: -.37 compared to -.34. This isn’t much, for sure, but you can also see its higher annualized return (for the period from 2010 until now).
Other Options:
- The biggest competitor for EDV is Pimco's 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ). It has a higher expense ratio (.15%) and its performance has essentially mirrored that of EDV, though slightly tilted towards better returns. Over the past 52 weeks, for example, EDV is down 23.4% and ZROZ is down 22.6%. Another plus for ZROZ is that its average duration is a little larger than EDV’s (about 27.5 compared to 24.4).
- iShares has their version for an extended duration STRIPS ETF in GOVZ. It carries an expense ratio of .15% and is down 22.8% over the past 52 weeks.
- If you're simply in the market for a Long-term Bond fund, then VGLT is my preferred asset (mostly because it is from Vanguard and I default to Vanguard when I can). TLT from iShares is the most popular Long-term Bond fund, though, and there is Schwab's version with the ticker SCHQ.If you are interested in even more volatility and exposure to more income rate risk, you could also consider TMF, Direxion's 3X Levered Long-term Treasury ETF. Of course, usual disclaimers about levered funds apply.