A Guide To Maturity-Date Bond ETFs

by: SA Editors

What Are They?

  • Maturity-date bond ETFs are unique in that they allow investors to hold a fund to maturity, much in the same way you would an individual bond.
  • These ETFs track an index of bond issues that come due in the same calendar year. The funds liquidate on December 31 of the listed year, offering investors a payout equivalent to the bonds' face value. Additionally, these funds make monthly distributions. The full value investors receive from these funds is equivalent to the face value of all the underlying holdings plus the sum-total of all yield payouts over the life of the fund.
  • Since individual holdings within maturity-date ETFs begin reaching maturity at the beginning of the stated year, the funds begin switching over to investment-grade, short-term debt in their final year, repositioning redeemed cash as issues reach maturity over the course of that year.

Why to Use Them

  • Maturity-Date ETFs solve a conundrum for fixed-income investors, who in the past had to make a choice between two imperfect options: bond funds or individual bond issues.
  • Standard bond funds are particularly susceptible to yield curve risk - especially in a low rate environment - as these funds are forced to regularly unload bonds at the shorter end of the yield curve while buying bonds at longer end of the curve (example: a bond ETF that tracks a 3-7 year bond index will constantly be selling bonds once they fall below 3 years to maturity and replacing them with bonds that don't mature for 7 years). In a rising rate environment where bond prices are falling, standard bond ETFs can experience loss of capital as they may be forced to sell individual bonds off for less than they paid for them.
  • On the other hand, individual bonds offer a high level of concentration risk. If an individual issue experiences a ratings downgrade, or defaults altogether, the result can be a significant loss of capital for the holder. Bond funds are generally sufficiently diversified to protect the holder from defaults or downgrades in individual issues.
  • Maturity-date bond funds offer the best of both worlds, so to speak. They allow investors to hold to maturity and rise out fluctuations in the yield curve, knowing that when the time comes, they can collect the full face value of the fund. And they get around the concentration risk inherent in holding individual bonds by holding a diversified basket of bond issues that come due in a given calendar year.

How to Use Them

  • According to Chris Parisi, National Sales Manager of BulletShares at Guggenheim, advisors have generally been using BulletShares ETFs in one of two ways: utilizing a 'core and satellite' approach, or building bond ladders to manage yield risk.
  • Core and Satellite Approach: Advisors are placing a single maturity-date ETF at the core of income investors' corporate or muni bond ETF portfolios and filling in the gaps with individual bonds. For more on core and satellite portfolio strategies, see this article from Investopedia.
  • Building a Bond Ladder: By spreading assets among a group of maturity-date ETFs that mature at regular intervals, investors can earn a consistent level of income while limiting the risk of having to sell bonds at below face value in a bear market. For more on building a bond ladder, see this article from Investopedia.

General Notes on the Different Bond Asset Classes Covered in This Article

  • Corporate bonds are a core component of diversified bond portfolios, as they offer greater returns and risks than government bonds. Due to their high level of interest paid, generally in the form of monthly distributions, corporate bond ETFs may be especially suitable for individuals approaching or already in retirement. However, corporate bonds - especially of the High-Yield variety - are more volatile than Treasuries and other Government-issued bonds and are thus not suitable for everyone (it all boils down to your risk tolerance).
  • The High-Yield bond spread is a widely-used gauge to determine the overall health of the credit market. Comparing the difference in yields between 'Junk' bonds and either U.S. Treasuries or Investment-Grade corporate bonds indicates a higher or lower risk of default among the lower-rated issues in the bond universe (a wider spread indicates a higher risk of 'Junk' bonds defaulting). Investors who feel the market has become overly bearish may wish to shift into higher-yielding bond ETFs as they feel the market is overestimating the chance these bonds will default relative to the yield offered.
  • Muni bonds are safer than corporate bonds but less safe than US Treasury bonds. So they tend to offer higher returns than Treasuries but lower returns than corporate bonds. Muni bonds are relatively illiquid -- they don't trade in large volumes, and buy-sell spreads may be wide. That makes them well suited to closed-end funds and ETFs, because fund managers can better manage the trading costs and spreads compared to individuals, and the ETF or closed-end fund structure reduces portfolio turnover compared to the traditional mutual fund structure.
  • The primary reason to own muni bond funds: your taxes. Interest from US municipal bonds is usually exempt from federal, state and local taxes if the bonds are issued in the investor's state (check with your accountant). However, some muni bonds are taxable, so you have to check the funds carefully.

What to Look Out For

  • As Roger Nusbaum points out, "As a practical matter, if I really wanted to target 2014 I might go with the 2015 fund, because the 2014 fund starts liquidating due to maturation as soon as January 15, 2014." This consideration is especially important when constructing a targeted bond ladder.
  • As with all ETFs, pay attention to spreads when getting in and out of these funds, as volume can be limited due to the targeted nature of holding bonds that mature in a single year.
  • Because these funds only own bonds that mature in a single year, the number of holdings they contain is generally less than 100 - often less than 50. This means great concentration risk in the case of a default or ratings downgrade than would be the case in a standard bond fund with hundreds or even thousands of holdings.
  • Because these funds can be held to maturity, there has been anecdotal evidence offered by Guggenheim Sr. Managing Director, Steven Baffico, of considerable share creation activity among the BulletShares ETFs, with almost no redemption activity. This creates the possibility for year-end capital gains distributions, as pointed out by IndexUniverse's Olivier Ludwig here. It should be noted that at this stage, the question of possible year-end distributions is purely speculative.

Further Reading

This page is part of The Seeking Alpha ETF Selector which sorts ETFs by type, highlights how to use them and what to look out for, and provides links to articles that discuss key issues for investors.