Recently the Fed announced that the $85 billion bond purchase by
the Treasury will continue. Up until this point the financial news
media seemed sure that the Fed would pare back their stimulus
program. Apparently, now is not that time. But at some point in the
future, the Fed will need to change its course. When it happens,
bond prices will be under downward pressure as interest rates rise.
Many investors, especially retirees and conservative investors are
investing in bonds either individually, through a bond mutual fund
or a bond exchange traded fund ((
)). Investors seem to associate bonds with safety, but this may not
be the case going forward. How can you protect your bond portfolio
in these uncertain times?
Defined maturity bond ETFs are relatively new to the financial
industry. The providers in this space are currently Guggenheim's
Bulletshares and iShares. These ETFs specifically aim to tackle
interest rate risk and protect yield to maturity. When purchasing a
defined maturity ETF the investor is receiving a basket of 100 to
200 bonds with a maturity date set for the year within the name of
the fund. For instance the Bulletshares 2020 fund will mature on
Dec 31, 2020. When this happens the fund is liquidated and the
proceeds are sent back to the investors.
Because this bond vehicle is an ETF, it can be purchased and
sold during trading hours making it very liquid and transparent as
the holding are disclosed daily. For investors that purchase the
fund, reinvest the payouts, hold until fund maturity (and assuming
that there are no company defaults within the portfolio) and the
principal is protected.
The defined maturity ETFs currently on the market all pay the
investor monthly. Regardless of interest rate movement you will
receive your locked-in yield, either in the form of interest
payments or principal repayment at maturity, depending on interest
rate movements and assuming that you hold the product until
maturity. In other words your monthly payment distributions will
vary with interest rates; but to ensure the locked-in yield at your
purchase NAV price, your principal repayment at maturity will
VS. Individual Bonds
The defined maturity bond ETF is similar to an individual bond
in its definitive maturity date but the similarities stop there.
Holding individual bonds increases the investors' default risk.
Holding a basket of 100 to 200 bonds does not eliminate this risk
but it does mitigate it significantly. Individual bonds also may
lack proper liquidity should an investor want to get out early.
Quality offerings are harder to find, and most individual bonds pay
semi-annually. Similar to individual bonds, the defined maturity
bond ETFs can be laddered to create the income and/or duration
goals of the portfolio.
VS. Mutual Funds
Bond mutual funds have only the bonds' asset class in common
with defined maturity bond ETFs. Bond funds do not trade intraday
and only disclose holdings quarterly making them less transparent.
They are designed to target a duration such as short, intermediate
and long term holdings, and have to sell bonds out of the portfolio
to maintain their duration mandate. Many of the bond funds are
actively managed bringing in additional risk of manager mistakes.
The cost of holding a bond mutual fund is also higher when
comparing fund fees and undesired capital gains passed through to
VS. Traditional Bond ETFs
Defined maturity bond ETFs are similar to traditional bond ETFs
in how they trade and in transparency. The main difference is
traditional bond ETFs are built for perpetuity. Traditional bond
ETFs are better used to simply gain exposure to bonds and asset
class movements, as their future income is difficult to predict.
For more aggressive investors or accounts that are smaller in size,
this vehicle is desirable. For more conservative to moderate
investors approaching or in retirement, the defined maturity bond
fund offerings appear to be a better choice when executed
Guggenheim VS. iShares
There are various defined maturity ETF products in the market.
iShares offers these products in the form of municipal bonds and
corporate bonds. Guggenheim offers defined maturityETFs in the form
of their Bulletshares, using corporate and high yield corporate
bonds. Defined maturityETFs from iShares and Guggenheim are indeed
similar yet have some notable differences. We compare the corporate
2018 defined maturityETFs of both providers below.
(click to enlarge)
We can see the expense ratio is lower using iShares' [[IBDB]],
however the yield is slightly greater using Guggenheim's [[BSCI]].
Also note that the bid/ask spread is markedly greater using IBDB,
decreasing tradability. If we hold these defined maturityETFs until
maturity tradability becomes less important if the investor
achieves the desired NAV purchase price to begin with.
Another difference in the products is how they unwind when they
near maturity. With iShares, during the final 12 months of the ETF,
as the individual bonds mature the money is transitioned into cash
and cash equivalents. Guggenheim utilizes the same basic approach
except that they time this process to coincide with the final 6
months instead of 12 months. While the iShares approach is
technically safer, it can be argued that the yield to maturity
suffers because of the earlier transition into lower yielding cash
Both iShares and Guggenheim provide a yield to maturity
calculator tool on their website for each of their specific defined
maturity ETFs. This provides investors a great tool to enter the
NAV price at point of purchase and see what their yield will be.
The yield will hold as long as the investor holds the ETF to
maturity and no bond defaults. As discussed earlier, risk of
default is mitigated by theseETFs holding a basket of many bonds
(usually 100-200) and default has been rare. In 3 years Guggenheim
has only had one bond default in their high yield corporate
category, and this had a very small effect of yield due to
diversification and capping.
The current list of defined maturity ETF products can be found
(click to enlarge)
Investors will want to place a limit order as opposed to a
market order when trading defined maturityETFs. A market order will
fill at the "market price" at the time the trade is placed.
However, with a market order an investor may not get all the
requested shares at one price or may get a very inefficient price
in thin trading. This occurs because of frequent price
fluctuations, and share availability at a given price. These
fluctuations are undesirable because yield is predicated on the
purchase price of the ETF. With a limit order, the order will not
fill unless all the shares requested can be purchased at or below
the investors' specified price, which should be set close to the
Bonds in this Environment
Bond prices will deviate from par value based on changing
interest rates. However, as maturity nears, the price will converge
and settle at face value. The past few years have been especially
tricky for investors in the bond market. The prime suspect for this
dilemma has been low interest rates. When interest rates rise bond
values decline because the coupon payments are based on these
interest rates. Conversely, when interest rates drop bond values
climb. Solely based on this an investor may think why should I even
bother investing in such an instrument, when interest rates are
already so low?
The answer is diversification and client behavior. Interest
rates are low, and based on current headlines and economic
valuations, investors could choose to stay away from bonds.
However, portfolio diversification with a long-term focus calls for
holding at least the core asset classes including bonds. Holding
bonds today give the portfolio a solid foundation for the next
When the stock market is climbing investors tend to move to
stocks when they feel better, causing them to buy near the top and
sell the bonds at the bottom. Then when the market falls they want
to get out because it feels bad to lose, causing them to sell the
stock low and buy the bonds high. This cycle only hurts the
portfolio, yet it is what we seem to think is normal - i.e., if the
house is on fire you get out. In portfolio management, successful
investment strategies using long term approaches such as those at
Vanguard are not exotic or nor do they provide for great water
cooler talk, but the results speak for themselves. The bottom line
is you want to hold bonds to protect you from you. The defined
maturity bond ETFs are new products allowing you to do this a
The figure below illustrates periods of rising and falling
interest rates, during both periods, bond returns have been
(click to enlarge)
I am long [[BSCE]], [[BSCF]], [[BSCG]], [[BSCH]], [[BSJE]],
[[BSJF]], [[BSJG]], [[BSJH]]. I wrote this article myself, and it
expresses my own opinions. I am not receiving compensation for it.
I have no business relationship with any company whose stock is
mentioned in this article.
The REIT Way To Become A Disciplined Dividend