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.