For most of its recent history, the U.S. investment management industry has focused its efforts on helping baby boomers accumulate assets, primarily through mutual funds, but increasingly through alternative vehicles such as exchange-traded funds. The results have been impressive, with assets in U.S. investment companies (which include mutual funds, closed-end funds, ETFs and unit investment trusts) growing from $3 trillion in 1995 to nearly $15 trillion as of the end of 2012, according to the Investment Company Institute.
With the oldest baby boomers beginning to retire, however, the investment needs of this massive generation are changing. Increasingly, baby boomers are shifting from the accumulation phase of their investing lives to the distribution phase. During the distribution phase, investors begin to draw down their savings to help meet their consumption needs. To a large extent, the investment management industry has failed to develop products that help retirees generate income while managing the liquidation of their retirement savings in an orderly fashion.
A new type of fixed-income vehicle, the target maturity bond fund, seeks to address both the savings and distribution needs of retirees by combining the benefits of bond funds and individual bonds. Target maturity bond funds invest in bonds that mature in a particular designated year of maturity. Each target maturity bond fund generally seeks to hold the bonds in its portfolio until they mature or are called. At the end of its designated year of maturity, each target maturity bond fund terminates and distributes its net assets to shareholders.
The Benefits Of Individual Bonds For Retail Investors
Financial advisors have long known that individual bonds offer unique features that render them particularly useful for retired investors. Unlike traditional bond funds, individual bonds pay fixed coupons and have maturity dates that provide for the return of principal to investors at a predetermined date, thereby allowing investors to estimate in advance what they can expect to earn from an investment in an individual bond.
More importantly, the sensitivity of a bond’s price to changes in interest rates, referred to as its duration by investment practitioners, declines as the maturity date of the bond approaches. In contrast, traditional bond funds are designed to operate in perpetuity and generally seek to maintain a relatively constant duration over time by rolling maturing or near-term bonds into long-term bonds on a regular basis. This means an investor has no way of estimating in advance what he can expect to earn from an investment in a traditional bond fund and may face an inappropriate level of interest-rate risk as the planned redemption of his investment draws nearer.
To illustrate how interest-rate risk can harm an investor seeking to withdraw assets from her retirement savings, consider an investor who expects to need to withdraw $50,000 five years into the future and is choosing between an investment in an individual bond with five years to maturity and a traditional intermediate-term bond fund. For simplicity’s sake, we will assume that the duration at the time of the investment for each instrument is five, which means that the value of the instrument can be expected to decrease 5 percent for each 1 percent increase in prevailing interest rates.1
At the time of the investment, both the bond and the bond fund have the same sensitivity to changes in interest rates. The problem arises as the investor’s need to access her money draws nearer. Four years after making the investment, the duration of the individual bond will have declined to one, while the duration of the intermediate-term bond fund will have remained around five. Accordingly, an increase in interest rates at that time would have a 500 percent greater negative impact on the net asset value of the bond fund than on the market value of the individual bond.