Defined Maturity ETFs: Innovation in Fixed Income

Defined maturity ETFs combine the benefits of individual bonds, bond funds and traditional fixed-income ETFs

Over the last several years, fixed income ETFs have represented the fastest growing asset class. Through the end of July, fixed income ETP AUM are up $35 billion versus being up $46 billion for all of last year[1]. Investment grade and high yield have seen the most growth year-to-date. Fixed income ETFs are still relatively new, with the first ETF being launched in 2002, and all indications are for continued growth in the future.   

The growth has largely come from broader adoption by advisors, who are utilizing fixed income ETFs in their asset allocation models. Many advisors have begun to embrace fixed income ETFs rather than purchasing individual bonds or bond funds. Defined maturity ETFs provide the precision of individual bonds, and the diversification benefits of bond funds.

 A History Lesson on Innovation

Over the past several years, a variety of fixed income investment vehicles have been introduced, including; open-end mutual funds, closed-end funds (CEFs), unit investment trusts (UI Ts), and exchange traded funds (ETFs). The structures have attempted to solve for the fixed income needs of advisors and the clients they serve. While individual bonds have filled the need for many years, it is not always easy to source bonds, and not all advisors are equipped to properly conduct credit analysis. Also, trading bonds can be a challenge in smaller increments.   

Traditional bond funds are often referred to as ‘perpetual’ maturity. The maturity of a bond fund will adjust overtime.  Therefore, the maturity may not meet the client’s targeted needs.  See scenario below:

If an investor purchased a bond today that was maturing in three years, they would typically receive monthly income payment and their principal back at maturity (three years). If the investor bought a bond fund, with a three-year maturity, in three years the fund would likely still have a three-year maturity. The fund manager would likely need to adjust the duration of the portfolio to adhere to the prospectus guidelines.

Fixed income ETFs have been a popular option due to their greater transparency of holdings, tax efficiencies and generally lower expenses than both mutual funds and individual bonds.  Fixed income ETFs can now provide broad exposure to investment grade, high yield, municipal, and sovereign debt. They are available across a multitude of maturities, from ultra-short to long-term. Fixed income ETFs have become the investment vehicle of choice for many investors.

While fixed income ETFs have been heralded as a convenient, low-cost alternative to both bond mutual funds and individual bonds, certain investment strategies such as building a laddered bond portfolio or obtaining targeted exposure to particular points on the yield curve were still only attainable through a direct investment in bonds. That is, until the introduction of defined-maturity ETFs—a recent structural innovation that has opened the door to new opportunities for bond investors.

Defined Maturity ETFs

Defined maturity ETFs combine the benefits of individual bonds, and bond funds, in a transparent and tradable structure. Defined-maturity ETFs are a fixed-term structure. At each fund’s respective maturity date, the fund will make a cash distribution to then-current shareholders of its net assets after making appropriate provisions for any liabilities of the fund.

Defined maturity ETFs provide the individual characteristics of a bond – monthly income payments and principal at maturity. Defined maturity ETFs also provide diversified bond exposure - with each fund holding 30-100 bonds from multiple issuers, reducing issuer concentration risk and potentially lowering portfolio volatility. Plus, defined maturity ETFs provide exchange-traded liquidity and transparency. ETFs offer daily holdings disclosure as well as the real-time pricing, intra-day trading and liquidity. 

Defined maturity ETFs combine the benefits of individual bonds, bond funds and traditional fixed income ETFs. These strategies allow advisors to manage to their client’s personalized and precise needs. Advisors can match the defined-maturity ETF, to their client’s specific time horizon.

How are Advisors Using Defined Maturity ETFs?

As previously discussed, defined maturity ETFs are ideal tools for laddering portfolios. Because of the finite maturities, advisors can use multiple defined maturity ETFs to spread their risk, and their stagger their maturities. Defined maturity ETFs can assist advisors in managing their client’s life-style needs.

Defined maturity ETFs have been embraced by advisors who are building laddered portfolios, require income to support their client’s life-style, or are seeking to meet certain client life goal needs (i.e., taxes, retirement, college funding, etc.). Defined maturity ETFs can assist advisors in building portfolios that provide predictable income through monthly distributions. The distributions can be aligned to meet client life-style needs. The defined-maturity, receiving principal upon maturation, can assist in meeting life goal events (i.e., taxes, retirement, significant purchases, college funding, etc.).

Advisors may choose to ladder their exposure by buying defined maturity ETFs, with maturities in 2013, 2015 and 2017. At the end of 2013, when the ETF matures, the advisor can then roll their exposure forward by purchasing the 2019. The advisor has effectively spread the risk over multiple years, and has been able to pick up yield by moving out on the yield curve. The defined maturity ETF structure allows the advisor to easily roll forward, with the added benefit of diversified corporate bond exposure.

Defined maturity ETFs represent an innovative solution to one of the biggest challenges for advisors. They provide investors the precision of an individual bond, with the diversification benefits of a bond fund.

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This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. 

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This material contains the opinions of the author but not necessarily those of Guggenheim Investments and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.



[1] SOURCE: BlackRock Investment Institute, Bloomberg. July 31, 2012

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