ETF Fixed Income Solutions For The Future

December 12, 2016

Another solution to the perpetual maturity of fixed-income ETFs is to retire the product at a specific date. Guggenheim and iShares have attracted quite a bit of attention and assets by building products that mature by slowly going to cash.

However, the inefficiency of these indexes has created anomalies and drift as the portfolios mature. The portfolios drift from the intended bond category, and many times, the more mature vintages generate negative yields to maturity.

There is a category of bonds that unintentionally may provide a solution to the maturity paradox. Build America Bonds were only issued in 2009 and 2010 as a way to assist states with debt issuance in response to the economic crisis. They are taxable municipal bonds, where the federal government guarantees part of the principal and coupon.

There is currently only one ETF dedicated to Build America Bonds: the PowerShares Build America Bond Portfolio (BAB). The characteristics of the fund are described below and compared to corporates and Treasurys: 

Category Ticker YTM Duration AUM Expense Ratio
Build America Bonds BAB 3.94% 9.7 $1.01 B 0.28%
Corporates LQD 2.97% 8.5 $28.75 B 0.15%
Treasuries TLH 1.67% 10.1 $0.56 B 0.15%
TIPS TIP 1.57% 8.1 21.1 B 0.20%

Source: ETF.com

Unintended Benefit Of BAB

The unintended benefit of the suspended supply of these bonds is that the index will have to mature. The constituents of the BAB index cannot be replaced; therefore, the fund’s duration must decline over time. This is quite different from most bond indexes, which have a semiconstant duration.

Most fixed-income indexes are designed to last forever, so as bonds age and their time-to-maturity shortens, they are gradually replaced in the index by newer bonds with more time to maturity, so that a fund’s overall duration remains relatively stable.

A bond fund that maintains constant maturity will realize losses on bonds it sells that have declined in price. BAB will eventually mature, meaning investors will likely get their principal back if they hold till the product is forced to close. This result can be an interesting solution for investors without the drift concerns with synthetically fabricated target maturities.

One of the greatest attributes of ETFs is their ability to democratize access to asset classes. With fixed income, that same access comes with a price of potentially changing the behavior of the asset.

In summary, when thinking about fixed-income investing, it is important to think more about your intended outcome rather than the past performance of the indexes.

I believe investors seeking consistent yield would be best served through a custom barbell strategy. For investors seeking a bond ETF that truly matures, the only ETF that actually provides this exposure is BAB.

At the time of this writing, Toroso had positions in PCEF, GSY & BAB. Toroso is affiliated with Global X Management Company. Toroso is a New York-based investment advisor focused on researching ETFs and other exchange-traded products, and designing asset allocation strategies, using ETFs that seek to perform well in various economic climates while emphasizing future objectives over past correlations. For more information about Toroso, call 646-465-5930, visit www.torosoinv.com or email [email protected]. For a list of relevant disclosures, please click here.

 

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