Evaluating Ladder Bond ETFs As Dry Powder Assets

Summary

• Sharp market drawdowns have been a frequent and hard-to-predict occurrence over the past few years.
• Investors who want to be able to inject capital into beat-up assets during drawdowns may wish to maintain a set of dry powder assets.
• We take a look at the Invesco and BlackRock ladder ETFs to see whether they can fulfill this role.
• We find BSBE and BSAE - two Invesco EM Debt funds - risk/reward very attractive though their current traded volumes are quite low at the moment.
• Looking for a portfolio of ideas like this one? Members of Systematic Income get exclusive access to our model portfolio. Get started today »

As the market continues to recover and grow progressively more expensive, investors may be starting to consider rotating out of more aggressively positioned assets. By holding some capital in assets that are able to hold their value relatively well through periods of volatility - those that we call dry powder assets - investors may be able to take greater advantage of market weakness. It's essential to think about these types of assets beforehand rather than try to improvise in the middle of a drawdown. As the former Treasury Secretary Tim Geithner used to say, "a plan beats no plan".

Last week we explored whether certain CEFs can play a role as dry powder assets. In this article, we take a look at a number of ladder bond ETFs - funds that hold bonds with specific maturities. Because funds with shorter-dated maturity bonds have lower duration and hence lower volatility and drawdowns they can be potentially used as dry powder assets.

Among the Invesco and BlackRock ladder ETFs we discuss in this article we currently like two USD Emerging Market bond funds:

• BulletShares 2022 USD EM Debt ETF (BSBE)
• BulletShares 2021 USD EM Debt ETF (BSAE)

These funds offer attractive yields for their March drawdowns. An important caveat is to watch their traded volume which is currently on the low side.

CEF Market Experiences Periodic Sell-offs

Over the last few years, it certainly seems like we have been seeing increasingly frequent sell-offs. Below is a list of just some risk-off episodes over the last few years:

• Mar-20: COVID-induced recession and liquidity crisis
• Dec-18: Concerns around hawkish Fed communication and QE unwind
• Feb-18: Volmageddon
• Nov-16: Election period interest-rate spike
• Nov-14: Commodity price crash
• May-2013: Taper tantrum

We can clearly see these periods in the behavior of CEF discounts which are highly sensitive to overall risk appetite more-or-less across the board. In other words, even if a CEF holds high-quality assets, it is likely to suffer a significant drop in price due to the fact that discounts tend to widen during periods of reduced risk appetite.

Source: Systematic Income

Signs Of CEF Market Overheating

Are there signs that investors can follow in order to gauge whether or not the CEF market is potentially overheating? In our view, yes.

The most obvious indicator among the handful that we follow on the service is the average CEF discount. Over the last few years, the average discount appears to have mostly traded in a range of about -10% and -2%. Once we start approaching the upper range, we would start thinking about building up a store of dry powder assets.

Source: Systematic Income

Another metric we like to follow is the yield differential between CEF sectors and their sector ETF benchmarks. Because investors who allocate to CEFs take additional drawdown and deleveraging risk it only makes sense to do this when the additional yield they receive on CEFs is adequate. Compression in the yields between the two types of assets has offered investors an opportunity to reallocate away from CEFs and wait for a better entry point.

Source: Systematic Income

Introducing Ladder ETFs

What we call ladder ETFs are ETFs that hold bonds maturing in a given year. The advantage of these products is that investors can tailor the yield of the fund versus its duration and credit risk. This is in contrast to funds that hold securities with a mix of maturities.

In this article we take a look at the following funds:

• Invesco BulletShares ETFs
• BlackRock iBonds ETFs

In total there are about 45 funds across 4 different credit sectors. BlackRock iBonds offer investment-grade corporate and municipal sectors while Invesco also offers high-yield and external emerging-market debt sectors in addition to these two sectors.

Fees on the funds range from 0.10% on the investment-grade funds to 0.42% on the high-yield funds. Liquidity is generally good outside of the emerging-market funds.

The Invesco funds are rebalanced on a monthly basis according to their index until six months prior to the maturity at which point no new constituents are added to the portfolio. At this point, the portfolio will start to transition to high-quality assets like Treasury bills or investment-grade commercial paper.

A glance at recent turnover activity in the investment-grade funds suggests that the portfolio turnover is on the order of mid-to-high single digits.

The investment-grade and municipal funds allocate to investment-grade rated bonds. This implies that by rebalancing out of securities that are downgraded to high-yield the fund is likely to be locking in losses and reinvesting in assets with a lower yield. This will create a small yield drag through the life of the fund.

Another important point to consider is the cash drag in the final year. This is due to the fact that these funds will hold bonds that mature at various points in the year and will begin to move into cash-like securities such as Treasury bills and investment-grade commercial paper. For example, the chart below shows the percentage of the BulletShares 2023 High-Yield ETF (BSJN) portfolio that remains outstanding i.e. non-matured for any given month up to the fund's maturity. This behavior suggests that investors who wish to remain fully invested should allocate to a fund that is at least 1-year from maturity.

Source: Invesco

Thinking About Ladder Fund Yields

Normally, CEF investors don't have to think about the yield of the portfolio securities. This is because CEFs hold securities with different maturities and call features. They can also dial or up down fund earnings using leverage and by rotating into higher or lower-yielding bonds.

Because ladder bond funds have more stable holdings and hold bonds with a specific maturity their yield is more fixed. In other words, we can say with much greater certainty what the current yield of the fund is to investors.

The chart below summarizes the yield components of BSJN across its portfolio holdings as well as its fund characteristics such as fund fees, typical bid/offer, and small premium-to-NAV. The reason we need to do this analysis is the fact that the advertised distribution yield on the fund's website is not actually the yield that the investor will experience. These additional drivers of yield are described below.

The coupon is simply the average coupon paid on the portfolio. The pull-to-par is the expected return as the bond's price converges to par on maturity. This is also roughly the difference between the yield-to-maturity and the bond's coupon. The optionality is the value of the bond's issuer call and is equal to the difference between the yield-to-worst and yield-to-maturity. This can be particularly large for municipal funds - eating up to a third of the yield to maturity. The fund fee, fund market bid/ask spread (divided by two and further divided by the fund's remaining maturity to turn it into a yield) and the fund's small premium to NAV are further drags on the investor yield.

Source: Systematic Income, Invesco

Although we can get a pretty precise yield figure from the ladder ETFs, we have to be a bit careful since they not only contain many different bonds but also rebalance periodically. The rebalancing will slightly shift the composition of the portfolio and hence the underlying yield over time. It will also have a drag in the form of trading costs. Finally, there is the cash drag that we described above. That said, this type of analysis is helpful in understanding the key drivers of investor income and return as well as in comparing funds to each other.

The Risk/Reward Balance

When looking for dry powder assets, investors will balance the drawdown they are likely to experience on the fund versus its yield. The relationship between the two metrics is relatively strong - the higher the yield the larger the drawdown the fund tends to experience.

Source: Systematic Income, Tiingo

The chart below shows yields on offer across the ladder ETFs (calculated as ETF yield-to-worst less fund fee) versus the total price drawdown over the past year. The chart below shows that the lowest drawdowns have been experienced in municipal funds (marked in orange), followed by investment-grade (marked in green) and emerging-market funds (marked in black).

The chart shows a few additional interesting things:

• The high-yield funds (marked in red), except for the 2020 maturity which is nearly 60% cash, have experienced drawdowns in excess of nearly all other funds
• Municipal funds tend to dominate investment-grade corporate funds in yield terms at drawdowns below 13%. This suggests that for investors looking to limit their drawdowns to low double digits in investment-grade assets can find better yields in municipal funds
• Emerging-market funds up to 2023 appear to be yield outliers for their recent drawdown. What's particularly interesting is that investors are not giving up much yield by shortening up on the maturity. For instance, the yield difference between the BulletShares 2021 USD EM Debt ETF (BSAE) and the BulletShares 2023 EM Debt ETF (BSCE) is just 0.33% while the drawdown goes from 9.4% to 4.6%.

Where does this leave us?

Across this set of funds, we like the two emerging-market debt funds:

• BulletShares 2022 USD EM Debt ETF (BSBE)
• BulletShares 2021 USD EM Debt ETF (BSAE)

They have delivered single-digit drawdowns while maintaining yields that are 3-4x those of municipal and investment-grade funds with similar drawdowns. One potential concern is that the traded volume of these emerging-market ETFs is quite low at present averaging a few thousand shares a day. If this remains the case then investors should diversify across other sectors as well as other types of dry powder assets which we will cover in the coming articles.

One reason for the attractive stance of the EM funds is that this reflects the persistent fact that emerging market debt tends to trade at wider credit spreads than US bonds for their credit rating. While the differential has narrowed through time it has diverged more recently. This dynamic is likely due to the fact that the Fed has announced their plans to buy US corporate bonds. However, given the fact that the Fed has purchased only a minimal amount to date, we think the current spread divergence is likely to compress in the coming months.

Source: Alliance Bernstein

On the fundamental side, EM corporates have tended to maintain a stronger leverage profile which has improved further in the last few years. In terms of holdings and taking BSBE as an example, more than half of the portfolio is in investment-grade and about a quarter is in sovereign paper. Top three exposures are in Russia, Turkey, and Mexican bonds - all three at around 10% of the portfolio.

Source: Alliance Bernstein

Conclusion

Those investors who wish to have a relatively stable store of capital available during future drawdowns should begin preparing a plan for building up a set of dry powder assets. A potential suite of ETFs that can fulfill this need are ladder ETFs which hold bonds maturing in a given year. This allows investors to control the type and extent of the duration and credit risk they are willing to take. Among the Invesco and BlackRock ladder ETFs, we currently like the Emerging Market funds that offer attractive yields for their drawdowns in March. An important caveat is to watch their traded volume which is currently on the low side.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Comments

[State72]

Very informative article. I will need to do some more research but this does look like a good way to calm the volatility of my portfolio.

[knoxmarlow]

Another good article. Thanks for sharing the ideas.

[gastro4]

ADS,
I have used defined maturity bond ETFs, Invesco corporates (BSC...) and ishares muni’s (IBM..), for a number of years for a percentage of the fixed income side of my portfolio. I guess at a certain age one becomes more concerned about return “of”, rather than return “on” capital. I’m happy to trade off the ER (.1 for Invesco, .18 for ishares) for the diversity of having hundreds of bonds which minimizes default risk (still never happy seeing NJ or Illinois bonds in a muni portfolio). I have set up these ladders going out 6-8 years.  
To avoid cash drag I always sell early in the year and roll the proceeds into the new end of ladder. The ishares munis all mature after May 31 of that year (so I sell and roll before May).
I have not looked at defined maturity EM bonds but will consider.
Thanks for article.

[ADS Analytics]

Thanks for the info on your experience.
ADS