Target Maturity Bond ETFs: Diversified Baskets, Single-Year Maturity
May 15, 2013
- Target maturity bond ETFs hold bonds that are all expected to mature in the same year.
- Current choices include investment-grade corporate bonds, high yield bonds and municipal bonds.
- These ETFs combine some features of diversified bond portfolios with some features of holding individual bonds.
Many investors use exchange-traded funds (ETFs) to get low-cost, diversified access to a variety of markets. Stock ETFs are widely known, and many investors have also become familiar with ETFs that hold portfolios of bonds with a fairly constant average maturity.
Fewer investors are familiar with target maturity bond ETFs, which hold diversified portfolios of bonds that are all expected to mature in the same calendar year. These relatively new ETFs can provide investors with some of the diversification benefits of a typical bond mutual fund or ETF, but can also provide some expectation of a certain maturity date, much like holding individual bonds.
The mechanics: How does it work?
Target maturity bond ETFs track indexes of bonds, much like other bond ETFs do. However, most traditional bond ETFs hold an ever-changing portfolio of bonds in order to maintain a more or less constant average maturity. For instance, a fund that tracks a benchmark such as the Barclays US Aggregate Bond Index will hold a wide variety of bonds, some with a long time until they mature and some with a shorter time. As bonds in the portfolio mature, the portfolio manager will reinvest the proceeds into other bonds. The manager might also sell some bonds that leave the underlying index and replace them with other bonds that are in the index. The overall effect is that the ETF is always invested in bonds.
Target maturity bond ETFs are different. For these funds, the underlying index is made up of bonds that are all expected to mature in a single calendar year, such as 2016. In the years prior to the maturity year, the ETF collects interest from the bonds in the portfolio and pays it out to shareholders, just like other bond ETFs do, but no bonds mature.
Then, over the course of the target year, the bonds in the ETF begin to mature. Instead of reinvesting the proceeds into other bonds, the ETF will hold the cash. By the end of the year, the expectation is for all of the bonds to have matured, leaving the ETF with only cash. At this point, the ETF distributes the cash to shareholders and closes down. Of course, shareholders are not obligated to hang onto the ETF until the very end of the target year; shares can be bought or sold any time on the normal stock exchanges like any ETF.
What's the yield?
Understanding the yield on target maturity bond ETFs can be tricky. Since interest rates have been falling in the market for many years, bonds that were issued long ago tend to pay higher coupons than bonds issued today. This means that investors are willing to pay more than the "par" value for those high-coupon bonds, which means that they trade at a premium to par value.
Let's look at an example. If a bond will mature for $1,000 in 2015 ($1,000 is its par value), it might be trading for $1,050 today. This bond would be said to be trading at a 5% premium to par value. However, the value of this bond will fall as it gets closer to maturity (since the borrower will only return par value, in this case $1,000, to the bond holders at maturity regardless of current interest rates).
This means that an investor who buys an ETF whose bonds are trading at premiums to par value will likely see the price of the ETF fall as the bonds get closer to maturity. The dynamic of high coupons and declining par value is reflected in the fund's "yield to maturity" calculation, which will generally be much lower than the fund's "weighted average coupon." The extra interest that these bonds will pay can still make them attractive but it's important to understand the yield calculation.
What are the choices among target maturity bond ETFs?
Currently, two different companies offer target maturity bond ETFs:
- Guggenheim Investments has BulletShares ETFs.
- iShares has target year municipal and corporate bond ETFs.
As with any newly launched ETF, investors would be well advised to monitor these funds to see that they have adequate assets and liquidity before jumping in.
The name BulletShares refers to the bond portfolio term "bullet," a strategy of holding bonds that all mature around the same time. There are two different groups of BulletShares:
- Investment-grade corporate bonds (from companies with relatively high credit ratings) currently exist for each year from 2013 to 2020.
- High-yield bonds (from companies with lower credit ratings) currently exist for each year from 2013 to 2018.
iShares has a family of target maturity municipal bond ETFs for each year from 2013 to 2018. The overall approach is similar to BulletShares, but the iShares funds hold municipal bonds, whose interest is exempt from federal income tax and in some cases the alternative minimum tax.
In April 2013, iShares launched target maturity bond ETFs for the years 2016, 2018, 2020 and 2023. These products invest in corporate-grade bonds, specifically excluding the financial sector from their holdings.
Uses for target maturity bond ETFs
Investors might use target maturity bond ETFs in a few different ways.
The first use is laddering. To build a bond ladder, an investor would normally buy a series of individual bonds maturing in a range of years. For instance, a ladder might consist of:
- $5,000 worth of bonds maturing in one year,
- $5,000 of bonds maturing in two years,
- $5,000 of bonds maturing in three years,
- and so on, through $5,000 of bonds maturing in ten years (or longer).
One difficulty with this approach is that it takes a relatively large amount of money to be able to buy bonds from enough different issuers to be diversified. A target maturity bond ETF might be a good tool in this situation because it holds bonds from a wide range of issuers while still fitting into a rung of the bond ladder.
A second use is for a specific capital need, such as paying for a child's college. Since target maturity bond ETFs are expected to become cash in a certain year, they could be useful tools for investors who will need cash in a particular year.
A third use is for interest rate positioning. If an investor believes that interest rates are likely to rise, they may want to hold shorter-term bonds, which are likely to lose less value in a rising rate environment. Short-term alternatives exist in target maturity bond ETFs, which become shorter-term as the target year approaches. One caveat, though, is that if you hold these ETFs until the end of the target year, you'll be left with cash to reinvest, which may or may not be what you're looking for.
What you should know
As with any investment, target maturity bond ETFs have risks that are important to understand.
The first risk is credit risk. Bonds held by these ETFs are either municipal bonds, investment-grade corporate bonds or high-yield corporate bonds. All three have the possibility of default, which would cause the ETF to lose value. This is no different from any fund that holds these types of bonds, nor is it different from holding the bonds directly, but it's an important risk to understand. Mitigating this risk somewhat is the fact that ETFs hold bonds from many different issuers, which helps to lessen the impact if one issuer were to default.
The second risk is interest rate risk. If interest rates rise, the values of existing bonds will generally fall, which would cause ETFs that own those bonds to lose value. The longer a portfolio has until maturity, the bigger the impact of this risk, so shorter-maturity ETFs have less risk here.
The third risk is liquidity risk. Target maturity bond ETFs are a relatively new innovation, which means that many of them have relatively small asset bases and little trading volume. It's especially important to be careful when you're planning to be trading (as against holding it for a longer term) an ETF that isn't very actively traded or widely owned. The spread between the bid price and ask price of illiquid ETFs can be wide, which means a higher transaction cost for investors.
Hitting the target
Target maturity bond ETFs aren't for everyone, but they might be useful tools for investors who want to combine the diversification of a bond fund with the expected cash payout date of individual bonds. Understand the choices, the uses and the risks, and you might be able to put this innovative tool to work in your own portfolio.
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