Innovation is a defining hallmark of the ETF marketplace. And perhaps, nowhere is this more apparent than with the recent introduction of maturity date ETFs (also known as target-date bond funds). Let’s analyze what maturity date bond ETFs are, what they offer and under what circumstances they might be used in client portfolios.
Maturity date bond ETFs are linked to an index of bonds that mature in the same calendar year. For instance, a bond ETF with a maturity date of 2018 is designed to automatically liquidate on Dec. 31 of that year. On the maturity date, investors receive a payment equal to the bonds’ face value.
Most individual bonds will pay semi-annual coupons, whereas maturity date bond ETFs pay monthly income. The entire value a bond investor receives from owning this type of fund is equal to the face value of the underlying holdings plus the total sum of all yield distributions for the life of the fund.
The purpose of maturity date bond ETFs is to give investors the benefits of individual bonds, but with greater diversification, less active management and lower transaction costs.
Today’s generation of maturity date bond ETFs are focused in the corporate bond and municipal bond market.
Guggenheim offers eight investment-grade corporate bond ETFs with maturities from 2013 to 2020. For investors willing to accept higher risk in exchange for higher yields, the company also manages six high-yield corporate bond ETFs with target dates from 2013 to 2018.
BlackRock offers four corporate bond ETFs (2016, 2018, 2020 and 2023) that specifically exclude bonds issued by banks and financial companies. Also in the mix are six AMT-free munibond ETFs with maturity dates from 2013 to 2018.
Although distributions for many maturity bond ETFs are monthly, some funds have less frequent distributions. It’s always best to check the fund’s distribution history and prospectus to estimate the type of income frequency you can expect.
“An investor who buys an iShares [maturity] bond fund receives a monthly distribution of earned income over a set term, for example, five years. And at the end of the period, they get a lump sum payment that represents all of the maturities of the bonds held in the fund,” explains Matt Tucker, head of iShares fixed income strategy.
As a result, maturity bond ETFs combine the benefits of individual bonds with regular income payments and a return of principal at maturity. And along the way, they maintain diversification, liquidity and transparency.
This niche also solves the conundrum facing bond investors who have to decide between conventional bond funds or individual bond issues.
Traditional bond funds are susceptible to yield curve risk, especially in a low rate environment. Funds are continuously selling bonds at the shorter end of the yield curve while purchasing bonds at the longer end. For example, a bond ETF linked to a 3-7 year bond index will sell bonds once they reach three years maturity or less and replace them with bonds that don’t mature for seven years. This can cause traditional bond ETFs to lose money during a period of rising rates (and falling bond prices) because they are forced to sell individual bonds for less than they paid.
To some extent, individual bonds allow an investor to customize the length of their fixed income exposure. But this type of flexibility comes at a rather high cost. Individual bond holders are subject to significant market risks, including the potential for credit downgrades along with issuer defaults. On the other hand, these types of risks are minimized in the context of a diversified bond fund.
In a sense, maturity date bond funds offer the best of both individual bonds and bond funds. Investors who hold their fund through maturity can ride out interest rate fluctuations and knowing they will collect interest payments plus their face value at the end of the term. And through the journey, they avoid the concentration risk associated with owning individual bonds.
“I see them as a way to build a bond ladder with more diversification, but also more cost,” says Rick Ferri, author of The ETF Book (Wiley) and founder of Portfolio Solutions. “I don’t see a use for then in most retirement savings plans.”
Ferri says that if a person is saving for retirement with a long-term horizon in mind and doesn’t have a specific dollar need at a known time, then it’s best to stick with a lower-cost intermediate-term bond index fund.
With a laddered portfolio of individual bonds, there can be extreme deviations in the risk characteristics of the portfolio, particularly with duration. Over time, the duration of a laddered bond portfolio drifts lower but suddenly spikes when cash flows are reinvested.
Concentrated bond portfolios are especially vulnerable to this effect. In contrast, bond funds are able to keep duration consistency because of ongoing cash flows that allow fixed income managers to make incremental purchases while keeping the targeted duration.
Bond liquidations or sales are another important factor for advisors to think about.
Even when deciding to sell one particular bond within a portfolio of individual bonds, the portfolio’s risk profile can be dramatically altered. The only way to preserve the bond portfolio’s target allocation is to sell a small percentage of each bond within the laddered portfolio. In most cases, this is unrealistic and cost prohibitive.
“Bond funds make liquidations, especially partial liquidations, notably easier,” observes a Vanguard research paper titled “Bonds or Bond Funds?” The study also notes: “An investor’s sale of fund shares does not change the characteristics of the fund’s bond exposure.”
Creating a bond “ladder” by purchasing individual bonds with different maturities is a popular strategy used to manage interest rate risk. Although this strategy ensures consistent income payments, it can be cumbersome to manage. For example, a short-term bond ladder would require an investor to buy five individual bonds with one, two, three, four, and five-year maturities. After the year one bond matures, the investor would subsequently buy a new five-year bond as a replacement.
An alternative strategy to achieve the same goal of a five-year bond ladder would be to invest in a maturity dated bond fund like the Guggenheim BulletShares 2018 Corporate Bond ETF (BSCI). The investor gets the benefit of regular income payments, but without the management and transaction cost of dealing with individual bonds. They can also choose to sell the fund before it matures, but if they hold onto BSCI until its 2018 maturity, they get a return of their principal.
Finding a Role
Maturity date bond ETFs, when used correctly, can serve practical purposes and solve real life financial problems. They are particularly useful when trying to match up assets with liabilities. Saving and investing for a child’s education is a perfect example of how a maturity date bond fund can be used.
A single year maturity product might work well if a person wanted to pay for a future expense by a given date, as with planning for college expenses. The timing and size of the expense are basically known. Simply choose the bond ETF appropriate to the desired time horizon and risk tolerance.
Being familiar with maturity date bond ETFs helps advisors think about simple solutions to complex problems.