Lowering Bond Portfolio Volatility

February 10, 2016

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Chuck Self, chief investment officer and chief operating officer at iSectors, an outsourced investment manager.

The first several weeks of 2016 have been volatile, and many indicators suggest this environment will persist. Historically, advisors have turned to bonds as the first line of defense against falling stock prices.

However, with the Federal Reserve raising rates last year and signaling it will continue to rise in the coming quarters, there is increased risk that bond portfolio prices will decline in the future. Most of the solutions in these conditions increase credit risk at a time of slower economic growth, or raise international risk with enhanced currency or political exposures.

Advisors can find another solution for their clients’ portfolios during times of market uncertainty in defined-maturity ETFs. The funds buy a certain class of bonds that will all mature in a given year. Investors receive monthly income from the fund, and in a specified month of the maturity year, the fund is closed and funds are returned to investors.

Guggenheim currently offers a suite of investment-grade corporate and high-yield defined-maturity ETFs under the BulletShares name, and iShares has iBonds suites for the municipal, corporate and corporate ex-financial sectors. Depending on the suites being analyzed, these providers have up to 10-year annual maturities.

Applying These To Portfolios

Many investors in these funds ladder maturities to receive a broad spectrum of holdings throughout the yield curve. A typical ladder will split a cash allocation into equal amounts and invest each portion into consecutive maturities.

For example, if an investor wanted to use $100,000 to build a corporate bond ladder using these types of funds, she can buy $20,000 each of 2017, 2018, 2019, 2020 and 2021 BulletShares Corporate Bond ETFs. In December 2017, when the Guggenheim BulletShares 2017 Corporate Bond (BSCH | B-48) comes due, she will reinvest the proceeds into a 2022 BulletShares to build a new “rung” on the ladder.

Where Are They Best Suited?

Defined-maturity ETFs are not for everyone because of their unique structure, but they can be a viable strategy for certain types of investors, particularly:

· Those wishing to control cash management: Many investors want to know, with certainty, the timing and amount of their interest and principal payments. Bond funds create challenges here, since the interest paid is based on the yields of the bonds currently owned. These payments will vary as the manager or index changes securities. Further, bond funds do not mature, so if a complete holding is sold, the amount received is based on then-current interest rates, which cannot be known with specificity in advance.

Defined-maturity ETF holders can ascertain monthly interest payments by analyzing past-year payouts on the issuer’s website. Estimated principal payment per share upon maturity should be close to that of the issuance price, although the issuer does not guarantee that this will be the case.

· Those positioning for less volatility as rates rise: The defined-maturity ladders will reduce price volatility in a secular rising-rate environment, which is especially important if the ladder may be sold before maturity for tactical investment purposes, or because of an unexpected cash flow need.

Advisors to clients who are sensitive to large principal losses will find these ladders useful. Often, if a client becomes comfortable with the ladder, they will be more willing to increase equity risk in their portfolio. Again, in rising-rate environments, the decrease in income received in a defined-maturity ladder—compared with a bond fund—may be a small cost to pay for increasing the probability of obtaining a client’s goal by taking the proper amount of portfolio risk.

· Those with a need for a fixed set of cash flows: These funds are great for funding a college tuition payment stream. In the year before a child enrolls in college, a ladder can be built with maturities in the December before fees are due. This will keep the funds working in relatively safe investments before tuition must be paid. This technique can be applied to any situation where there is a short- to intermediate-term annuity, with somewhat certain amounts, that needs to be funded.

As investors and advisors prepare for this year’s anticipated volatility, concerns will continue to mount about the safety of investor portfolios and where they can find secure and consistent income. Although not for everyone, defined-maturity ETFs may have a place in many client portfolios and should not be overlooked.

At the time of this writing, iSector clients held many Guggenheim BulletShares Defined Maturity ETFs. Chuck Self, MBA, CFA, is chief investment officer and chief operating officer at iSectors, an outsourced investment manager that provides advisors access to their proprietary asset allocation models based on low-cost index ETFs designed with various risk tolerances. He has more than 30 years of experience in the investment management industry.

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