When it comes to fixed income investing, investors basically have one major choice to make for their portfolios: buy a bond fund or buy an individual bond itself. Both choices offer pros/cons and present different risks/rewards. The problem is that the decision isn’t always an easy one. Choosing incorrectly could leave portfolios exposed to lower returns and potential losses.
However, there may be a way for investors to have their cake and eat it too.
Target-date maturity exchange traded funds (ETF) could offer the best of the both worlds. And yet, they are underutilized by investors. These products provide many of the benefits of bond funds and individual bond investing within one ticker.
Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.
Bonds & Bond Funds Combined
Bonds are often cited as ballast for portfolios. That’s because when a bond matures, investors get their principal back. So, if you purchase $1,000 worth of 10-year Treasury bonds today, in a decade, Uncle Sam will hand you a check for the grand. This is the benefit of owning an individual bond.
Most of us, however, buy our bonds via a fund. This provides instant diversification, allowing us to spread our investment over many different bonds. So, that same $1,000 invested in the Vanguard Total Bond Market Index Fund ETF (BND) now provides exposure to more than 10,000 bonds.
Nonetheless, neither product is perfect. With an individual bond, you lose the diversification benefit and default risk increases. For bond funds, interest rate risk surges. Because they have to roll over their portfolios to match mandates, bond funds can result in losses.
However, there may be a way to combine the benefits of both products into one. And that’s a target-maturity or target-date bond ETF.
These funds function like a traditional bond ETF or mutual fund. With one ticker, investors gain exposure to a wide swath of issues. This limits default risk. The kicker is that these funds have a maturity date and end date, just like an individual bond. As bonds in the ETF are repaid and hit their maturity date, the ETF will make one final distribution of the fund’s NAV back to its shareholders. This allows investors to ignore the whims of interest rates (like owning a regular bond provides), while still gaining diversification benefits (like a bond fund).
And like a bond fund, these ETFs pay a monthly dividend. Individual bonds tend to pay semi-annually or strictly at maturity.
The beauty is that target-date bond ETFs come in a variety of flavors, from long-to-short timelines as well as credit risk and tax status. For example, Invesco BulletShares 2024 USD Emerging Markets Debt ETF (BSDE) holds emerging market debt, while the iShares iBonds Dec 2023 Term Muni Bond ETF (IBML) holds tax-free muni bonds.
Using Them to Your Advantage
Given their uniqueness and advantages, target-maturity bond ETFs are a great tool for a variety of portfolio needs.
In a bond ladder, investors buy individual bonds in increasing maturities. Bonds with longer maturities tend to pay higher interest rates than those of shorter maturities. The idea is that investors are protected from rising interest rates, but still get a higher blended current yield. As shorter-term bonds mature, investors reinvest the proceeds in a longer dated issue, thereby getting a higher yield as rates rise. If rates are falling, investors can use the proceeds to invest in other places.
However, a bond ladder exposes investors to default risk. With a target-date bond ETF, investors can easily layer a few different ETFs of different maturities to create the same effect, but with added diversification benefits. Moreover, initial investment minimums for the ETFs are substantially less than when individual bonds.
Another usage could be time purchases and other future expenditures. Because they have an end date, target-date bond ETFs can be a valuable tool to income planning. For example, an investor can use them in a bucket approach and have 2-3-years’ worth of spending in these products. This allows for the rest of a portfolio to be fully invested and can provide “sleep at night” volatility damping. Investors can use them to bridge gaps in retirement and Social Security usage or even for long-term care potential.
Finally, target-date bond funds could be part of the college funding equation. 529 plans are wonderful vehicles for college savings, but they do have their downfalls. Only approved expenses qualify for tax-free withdrawals from these plans. Off-campus housing, groceries, college-logoed sweatshirts and late-night munchies on the quad are very much a part of the American college experience. By using four target-date bond ETFs, parents can have a pool of dedicated money that matures each year of school to help pay for these “necessities.”
These are just some examples of the benefits and usage of these ETFs.
Making a Maturity ETF Play
Given the income planning ability of these funds, investors and advisors should consider them for their portfolios, as they work in a variety of situations. Right now, investors looking to purchase have two choices: iShares or Invesco. Both have deep benches and offer a variety of funds covering everything from junk and emerging bonds to Treasuries and municipalities, allowing investors to look at different credit ratings and taxable/tax-free income.
Expense ratios are cheap too. Investors can get exposure to some asset classes at just 0.10%.
Looking forward, several other fund shops have filed for new target-maturity ETF suites. This will bring plenty of additional choices to the market.
The bottom line is that Target-Date Maturity Bond ETFs offer a great tool for portfolios. Offering benefits of individual bonds and bond funds, investors should consider them for their income planning needs.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
