Can Target-Maturity Bond ETFs Replace Individual Bonds?

October 02, 2017

[This article appears in our October 2017 issue of ETF Report.]

Buying individual bonds to ladder for clients’ needs comes with its own issues, such as varying returns and having to keep them in a separately managed account. Even on the ETF side, most bond ETFs keep constant maturities that open investors to duration risk.

Enter target-maturity bond ETFs. These funds hold fixed-income investments with similar maturities, varying by year. The instruments are held to maturity, and when that happens, the fund closes and all cash is returned to investors.

There is about $12 billion in 42 target-maturity bond ETFs, with Guggenheim’s BulletShares and the iShares iBonds Term families the two issuers of these funds. There are corporate, municipal and high-yield versions of the bonds, with maturities covering each year from 2017 to 2026. While these look to be convenient ways for advisors to diversify risk for multiple clients at a time, are they good tools?

Useful Tool
For the most part, market watchers say yes. Both Todd Rosenbluth, director of ETF research for CFRA, and Nathan Behan, senior vice president in investment research for Envestnet | PMC, say these ETFs are particularly good for diversification because the funds hold hundreds, maybe thousands, of bonds in the single maturity year.

“[It helps] to spread around the risk of either a company paying back debt too quickly and calling the bonds, or more importantly, risk of downgrades or defaults,” Rosenbluth said.

That’s particularly important for investors in the high-yield market, Behan notes: “You don’t want to build a small portfolio of 10 to 15 bonds. The default risk gets to be pretty high.” Target-bond ETFs also allow advisors to give all their clients the same bond-laddering returns and experience, assuming they have the same investment time period—another benefit, he adds.

Another primary benefit of these ETFs is they help insulate investors from rising interest rates, says Michael Krause, president of ETF Research Center. With the Federal Reserve starting to raise rates, this may be why these funds are becoming popular.

 

Can Target-Maturity Bond

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Advisors looking to add these funds to clients’ portfolios need to be cognizant of a few factors specifically related to these funds, the sources note.

Rosenbluth says these ETFs tend to be used in buy-and-hold strategies, rather than as trading vehicles, like other bond ETFs. So that means volume can be lower versus ETFs of comparable size. While he doesn’t consider the liquidity to be an issue—since these are meant to be held until maturity—investors need to understand that the liquidity of these funds may not be what they expect. Lower liquidity may mean an investor could face higher costs if they try to get out of the fund ahead of maturity, Behan points out.

Competing Issuers
Looking at the funds themselves, both Guggenheim and iShares offer corporate target-date bonds with maturities to 2026. Only Guggenheim offers a high-yield target-date bond selection, with maturities to 2024, and only iShares has a muni target-date bond family, with maturities to 2023.

Fees are also different. Guggenheim’s fees are 0.24% for its corporate bonds and 0.43% for the high-yield, while iShares set its fees at 0.10% for the corporate bonds and 0.18% for munis.

Expenses are a consideration, Behan notes, and advisors using these ETFs need to compare the cost of using these products versus the individual investor’s breakeven point. He considers the expense ratio on Guggenheim’s products to be costly.

“The long-end ones are eight to 10 years out. You’d pay 25-50 basis points every year for 10 years; that’s a big expense ratio to pay for bonds you essentially tend to keep until maturity,” Behan said. “There’s no free lunch. You have to pay for the diversification. The cost is the expense ratio and building that portfolio for you.”

Rosenbluth counters, though, that despite iShares’ lower fee, Guggenheim’s products have considerably more assets, and their volume is more than double in its product, something also to consider.

When comparing the two corporate bond ETFs, Krause says all target-date 2017-2021 funds have a median S&P rating of A-, while all funds with target dates between 2022 and 2026 have a median score one notch lower, at BBB+.

Excluding the 2017 maturities, he calculated the yield-to-maturity for the bonds in the portfolios and saw the Guggenheim had slightly higher yields across the range of target dates. However, he notes the Guggenheim funds may have “the same median credit rating as their iShares counterparts; in aggregate, the Guggenheim funds are slightly more risky.”

Do Your Due Diligence
Like any bond fund, understanding credit risk is necessary, both Krause and Rosenbluth say, as is an investor’s comfort with taking on that risk.

“I saw data from S&P credit ratings that said the likelihood of the default rate is down and is trending lower, but there’s still risk from any high-yield bond issuer facing challenges,” Rosenbluth explained.

Any defaults might also eat into returns, says Krause.

Aside from the credit risk in these holdings, Behan notes that advisors thinking about using these funds need to do the usual due diligence they would do for any ETF.

The current economic climate—with the U.S. economy growing and corporate earnings still strong—remains conducive for investors in high-yield products, and the spreads have tightened, Rosenbluth adds. However, he re-emphasizes that there’s still risk. That’s why the diversification of owning the ETF is a very significant positive versus owning individual bonds. And it’s much easier to use an ETF versus trying to do bond laddering using a mutual fund.

“It’s much harder to do bond laddering in a mutual fund, because you don’t have that state of control. A manager might have a short-term focus or a long-term focus, but short-term could be bonds maturing in 2019-20-21, and you may have a college payment for your kids in 2020,” he explained. “The ability to control that with a Guggenheim or an iShares product is important.”

 

Can Target-Maturity Bond

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