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Short-Term Goals on the Way to Long-Term Success
I recently had my air conditioning system inspected. As the technician and I stood atop my roof regarding my condenser, he took on the aspect of a veterinarian examining a beloved pet whose future he knows to be certain and short. "I think you've got one, maybe two summers left in it … one day, it's just going to go," he said gently, and then in a more businesslike tone, "At which point we can get you a replacement."
Surveying the condenser for a moment and accepting its approaching mortality, I asked how much the replacement might cost. The answer made me wince, and I knew I had to make some tweaks to my portfolio.
When we think of defined liabilities, we usually think of retirement. From fresh hires getting their first 401(k)s to municipalities struggling under the weight of pension obligations, retirement is the distant goal we spend serious time contemplating and planning for, in the hopes that our portfolio can eventually support the transition.
But in the meantime, life beckons! Those of us in our 20s and 30s certainly hope to retire one day, but in the preceding decades there are vacations to take, down payments on homes to make, weddings to plan, and air conditioning condensers that will need to be replaced. As financial planners often remind us, we never know when we are going to step off the curb and get hit by a bus, so I see nothing wrong with spending time planning for these short-term goals in the same way I do for my major long-term goal, retirement.
So what's our strategy? If we come up with a rough dollar figure - quoted by an HVAC technician or otherwise - and fairly definitive time frame, what is the best option for investing those funds until the day arrives they are needed?
Looking Beyond Traditional Options to Defined Maturity Bond ETFs
Equity markets are the traditional go-to for young people's assets, and for good reason. When considering a long-term goal like retirement, equities give us the best chance for growth, but in the same way a baby boomer has (hopefully) long since started to move towards a more conservative portfolio as the period of their defined liability approaches, so too a pure equity approach is - in my opinion - too risky for a young person's defined liability investments. A quick and dirty answer might be to use a target date retirement fund - but whereas an actual retirement goal could be 2050, perhaps the money for the air conditioning condenser should go into a 2020 target date fund. Better than a pure equity approach, but I think it still contains too much risk, especially with asset allocators falling over themselves to argue that, yes, equity markets are extremely expensive, but not insanely extremely expensive.
Looking at Vanguard's Target Retirement Fund family (the leader in the class, with over $240 billion in assets as of September 30, 2018) even the 2020 target date fund has over 50% of its assets in equities - 32% domestically, 21% internationally. It does have a comforting 29% allocation to domestic fixed income, but those assets are in an intermediate duration bond fund at a time when interest rates are rising. Even if we were okay with having some allocation to equities in the defined liability portfolio, should we invest in something with so much interest rate risk in a rising rate environment?
Stuck between the rock and hard place of lofty equity valuations and a challenging interest rate environment, there doesn't seem to be a neat option for a defined liability two to five years in the future. Until, that is, we look at defined maturity ETFs, specifically those for high yield bonds.
For those unfamiliar with defined maturity bond funds and ETFs, they blend the diversification benefits of a traditional bond fund with the maturity profile of individual bonds. Defined maturity products actually … well, mature! Unlike the perpetual nature of most fixed income vehicles, they will not continuously rebalance to follow an index whose roughly constant duration requires selling shorter maturity bonds to buy longer maturity bonds. A defined maturity product will assemble a portfolio of bonds that all mature (or will be called) in the same year, and actually return the principal to the investor in that year - ideal if we know that's just when we will have a major expense to offset.
Defined maturity products had an initial moment in the sun several years ago with the first rumblings of higher interest rates, but at that time they were mostly evaluated in a framework of owning, say, a ladder of defined maturity municipal bond ETFs versus a single bond fund - i.e., the framework of an older investor much more focused on safety and income (the second word of a Barron's analysis from 2014 is "retirees"). For our needs, we need to shift the spotlight to a different arena - the BulletShares defined maturity high yield bond ETFs.
"Any customer can have a car painted any color that he wants so long as it is black."
Out of the universe of financial products, why do I prefer the BulletShares platform for high yield defined maturity ETFs? To paraphrase the famous Henry Ford quote that heads this section, we can have any defined maturity high yield bond product we want, as long as it's BulletShares … because Invesco is the only one that offers such products! No other asset manager has high yield defined maturity options in ETF or mutual fund form.
Not to say that the space is immature. To look at the two largest defined maturity ETF providers in more detail, the primary rival to Invesco's BulletShares ($9.7 billion in assets) is BlackRock's iBond ETF platform ($5.8 billion). Both offer defined maturity ETFs for investment grade corporate bonds, while BulletShares also has high yield corporate and emerging market dollar-denominated debt options, and iBond extends into municipal bonds.
This begs the question of why we should prefer the high yield bond options as opposed to corporate or municipal bonds. The primary driver is the compelling return, which I discuss in depth below. Equally important, of course, is the risk. With the economic backdrop remaining supportive, the high yield default rate is low - Moody's Analytics expects it to drop to around 2% by early next year. Of course, we should be mindful that the economy could weaken over the several years to our defined liability coming due, but while high yield bonds are a pro-growth asset more highly correlated with equities than investment grade fixed income, drawdown analyses show they offer significantly more downside protection than equities when markets collapse (as they should, being higher in the capital stack).
Meanwhile, the defined maturity feature lets us lock in today's purchase yields so we can ignore the interest rate risk that might otherwise wipe out some or all of our return depending on the path of interest rates over the next several years. So from a risk perspective, they offer a nice balance between the potential volatility - and downside risk - of stocks, and the safety - but unimpressive returns and interest rate risk - of investment grade fixed income.
Returns and Bond Math - Don't Forget Your Amortization or Taxes!
Let's examine the potential returns in more detail. BulletShares offers high yield bond ETFs out to 2026, which I think is about as far as we need for short-term defined liabilities. Indeed, if we use the old rule of thumb of a market cycle being 7 years, anything beyond 2025 would seem to be distant enough for equities' risk/return profile to regain primacy over fixed income investments.
Below is a list of the BulletShares high yield product suite (except for the soon-to-mature 2018 ETF, which I exclude) with some key data points highlighted:
|Ticker||Name||Yield-to-Worst||# Holdings||Assets ($ millions)|
|BSJJ||Invesco BulletShares 2019 High Yield Corporate Bond ETF||5.23%||129||$1,140|
|BSJK||Invesco BulletShares 2020 High Yield Corporate Bond ETF||5.76%||127||$953|
|BSJL||Invesco BulletShares 2021 High Yield Corporate Bond ETF||5.65%||158||$499|
|BSJM||Invesco BulletShares 2022 High Yield Corporate Bond ETF||6.19%||186||$261|
|BSJN||Invesco BulletShares 2023 High Yield Corporate Bond ETF||6.40%||164||$126|
|BSJO||Invesco BulletShares 2024 High Yield Corporate Bond ETF||6.30%||135||$56|
|BSJP||Invesco BulletShares 2025 High Yield Corporate Bond ETF||7.12%||116||$26|
|BSJQ||Invesco BulletShares 2026 High Yield Corporate Bond ETF||6.32%||33||$5|
|Data as of 10/25/18 from BulletShares website: Invesco - BulletShares - Strategies|
Recall that because most high yield bonds have options embedded in them, we need to focus on yield-to-worst rather than yield-to-maturity. And indeed, we see the yields on offer look compelling, but we need to do a bit more work. For one, these numbers are gross of fees (fixed at 0.42% for all the products listed, compared to 0.40% for the SPDR Bloomberg Barlclays High Yield ETF (JNK) and 0.49% for theiShares iBoxx $ High Yield Corporate Bond ETF (HYG), the heavyweight high yield bond ETFs with over $22 billion in assets between them) and we also need to take into account any purchase premium or discount.
ETFs, unlike mutual funds, do not necessarily trade at net asset value (NAV). If we purchase an ETF at a premium to the underlying NAV, we need to amortize that cost over the life of the product, reducing our return. Similarly, if we manage to buy at a discount to NAV, we will get a boost to our return. Both Invesco and BlackRock have online calculators to help you determine a Net Acquisition Yield - what we should actually expect to realize after accounting for expenses and amortizing any premium or discount. For simplicity's sake, I use the same methodology to calculate the Net Acquisition Yield for each product (see the formula for the calculation below the chart):
|Ticker||Name||Yield-to-Worst||Net Acquisition Yield|
|BSJJ||Invesco BulletShares 2019 High Yield Corporate Bond ETF||5.23%||4.81%|
|BSJK||Invesco BulletShares 2020 High Yield Corporate Bond ETF||5.76%||5.39%|
|BSJL||Invesco BulletShares 2021 High Yield Corporate Bond ETF||5.65%||5.30%|
|BSJM||Invesco BulletShares 2022 High Yield Corporate Bond ETF||6.19%||5.79%|
|BSJN||Invesco BulletShares 2023 High Yield Corporate Bond ETF||6.40%||6.02%|
|BSJO||Invesco BulletShares 2024 High Yield Corporate Bond ETF||6.30%||5.89%|
|BSJP||Invesco BulletShares 2025 High Yield Corporate Bond ETF||7.12%||6.70%|
|BSJQ||Invesco BulletShares 2026 High Yield Corporate Bond ETF||6.32%||5.78%|
|Data as of 10/25/18 from BulletShares website: Invesco - BulletShares - Strategies|
|Net Acquisition Yield = Yield-to-worst - Expense Ratio +/- Amortized Purchase Discount/Premium. Amortized Purchase Premium/Discount is calculated as (NAV-Purchase Price)/(NAV*Effective Maturity), with NAV as of 10/26/18 and Purchase Price equal to the last trade on the same day. I assume no transaction costs.|
A few basis points of additional drag beyond the expense ratio have been added here and there, but overall the yields still look compelling. As a final step, we should think on an after-tax basis - it's easy to be seduced by high yields, but when we're paying ordinary income rather than qualified dividend tax rates, we should double-check our math.
One of the advantages (if we can call it that) to being a young person is that we are less likely to be in the top tax bracket. Under the recent tax legislation, an individual's marginal tax rate is 24% until he or she earns more than $157,500 ($315,000 if filing jointly). According to DQYDJ's nifty income percentile by age calculator, which conveniently digests Census data for us, less than 5% of workers under age 40 earn more than this amount (if you're one of the fortunate 5%, I won't be hurt if you decide to close the tab at this point) so it's a reasonably conservative assumption for a tax rate. A 24% marginal tax rate is far less punishing than 37% plus a 3.8% Medicare surtax the top bracket (read: older people) pay. On a tax-equivalent basis, with a 15% qualified dividend rate, you'd need something that paid dividends in excess of 4% and approaching 6% depending on the specific ETF you're examining:
|Ticker (Maturity Year)||Yield-to-Worst||Net Acquisition Yield||After-Tax Return (@24%)||Tax-Equivalent Div. Yield (@15%)|
|Data as of 10/25/18 from BulletShares website: Invesco - BulletShares - Strategies|
I submit that I would rather own a single ETF rather than do the work to assemble and manage a diversified portfolio of high-dividend stocks, which even then would almost certainly be more volatile than a diversified high yield bond ETF, just to offset a single liability over such a short time period. Save that time and analytical effort for your retirement portfolio!
Make Sure It's Not a Lemon: Kicking the Tires on Diversification and Credit Quality
Headline return figures are all well and good, but we also need to check under the hood regarding portfolio construction and diversification to make sure we're not missing anything. For starters, we can examine the construction methodology of the underlying indices the ETFs track and compare them to those of more traditional high yield bond ETFs, HYG and JNK. BulletShares ETFs follow the Nasdaq BulletShares High Yield Indices. Reading the relevant documentation shows a lower minimum size for index inclusion (at least $200 million outstanding par amount as opposed to $400 million for HYG and $500 million for JNK), and a higher cap on the maximum weight per issuer (5% for BulletShares vs. 3% for HYG and 2% for JNK). But, otherwise, it looks very similar to traditional high yield bond indices.
Moving on to actual portfolio holdings of BulletShares ETFs by credit quality and industry diversification, both look right in line with the competition. For the former, the breakdown of BB, B, and lower-rated bonds varies somewhat by ETF. But the overall average fits nicely with what we see for HYG and JNK:
|Credit Quality (S&P)|
|Ticker (Maturity Year)||BB||B||CCC/Not Rated|
|Data as of 10/25/18 from BulletShares website: Invesco - BulletShares - Strategies HYG and JNK data taken from their respective fact sheets on the same date.|
We see similar variation by maturity year for industry diversification, but an overall average that is once again in line (note that JNK aggregates holdings into only three industries, making a direct comparison difficult):
|Ticker (Maturity Year)||Telecomm-unications||Consumer Discretionary||Financials||Health Care||Energy||Industrials||Materials||Utilities||Consumer Staples||Information Technology||Real Estate|
|Data as of 10/25/18 from BulletShares website: Invesco - BulletShares - StrategiesHYG and JNK data taken from their respective fact sheets on the same date.*HYG discloses "consumer non-cyclical" holdings, which combines consumer staples and healthcare.|
As a final note, the maturity process of BulletShares ETFs (11 of which have successfully matured since 2011, providing a proven track record for us to follow) involves investing proceeds from matured bonds into 3-month Treasury bills during the final year of an ETF's existence. All proceeds are distributed when the last bond matures. As such, the interest rate on those T-bills has a significant impact on the return of the shorter maturity funds in particular. I view this as another reason to invest in BulletShares; if interest rates rise, we will both have dodged the bullet of holding interest-rate sensitive "perpetual" bond funds, as well as gained the chance to invest our cash at a higher rate. If interest rates are lower, this suggests the economic environment has weakened, with a potential equity market downdraft to match, so while our cash might be invested at a lower rate we have protected our funds from a larger loss.
What Could Go Wrong?
This analysis has focused primarily on the mechanics and holdings of the defined maturity product - if we find those satisfactory, we are back to the key drivers of returns: interest rates and defaults. From a rates perspective, locking in a purchase yield has the opportunity cost of missing out on the ability to do the same if interest rates rise (although we would need to make assumptions about the returns on the reinvestments from our coupon payments as well.)
From a default perspective, if the economic environment deteriorates, default rates will likely rise. As the previously linked Moody's Analytics report showed, high yield defaults peaked at over 14% during the Great Recession, and above 10% in the recession following the tech bubble collapse. While defaults do not translate into a complete write-down of the bonds (average recovery rates on unsecured high yield bonds are in excess of 40%) they need to be factored into our return calculations.
Also worth mentioning is that a by-product of this strategy is that, while the ETFs themselves have intraday liquidity, we are essentially making these assets illiquid by holding them until maturity and a final distribution. If we have an emergency that forces us to sell along the way, or our short-term goals change such that the portfolio is no longer necessary, we could be forced to sell at a loss if interest rates and credit spreads have moved against us - the very risks we were trying to offset by using a defined maturity product in the first place.
In summary, for younger investors attempting to build portfolios around near-term "defined liabilities," BulletShares defined maturity high yield bond ETFs offer a compelling purchase yield that can, unlike most bond funds or ETFs, be locked-in, while avoiding the risks of full bore equity positions that are more appropriate for long-term liabilities like retirement. By definition, this idea requires a well-defined dollar amount and date for a liability, but it allows us to think intelligently about goals that are no less critical to our well-being on our path to the long term.
Disclosure: I am/we are long BSJJ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.