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Climbing The Defined-Maturity Guggenheim Bond Ladder

THIS IS A REPRINT OF AN ARTICLE THAT APPEARED AT LEAST 72 HOURS AGO ON FORBES.COM

Conventional fixed-income ETFs are not the reduced-risk investment many expect. Actually, they are aggressive active bets on the direction of future interest rates. That gamble worked magnificently for most of the past 33 years. But unless we expect substantial negative interest rates (i.e. huge taxes against savings), that play has to sour going forward. To achieve what we really want from fixed income, we need maturity dates, something we get from Guggenheim's "defined maturity" ETFs.

The Problem

To manage interest-rate risk, bondholders adjust maturity (specifically, "duration," a more sophisticated measure that blends the maturity date, the magnitude of the coupon and interest on interest, but we can get a sense of what's going on if we just think in terms of maturity). If you expect rates to fall, you want the longest maturities or durations you can get, which is why never-maturing fixed-income ETFs have made so many investors so happy - so far. But when rates rise, we prefer shorter maturities or durations (so we can more quickly get our money back to reinvest at higher yields). When rates rise, fixed-income securities that never mature are the worst things you can have. (See this 9/30/15 post for more details).

Traditional fixed-income ETFs like iShares iBoxx Investment Grade Corporate Bond ETF ($LQD), a robo-adviser favorite, publish statistics for duration and maturity. But those numbers are meaningless; they're nothing more than marketing bullet points. Such computations require defined maturity dates, which don't apply to $LQD (they apply to individual bonds owned by $LQD, but those are never cashed in and the values are never paid to shareholders; instead, this permanent portfolio sells them as they age and replaces them with other, younger, bonds). So you don't really have a stake in fixed-income. Instead, what you have is something like a British Consol, a class of permanent fixed-income securities redeemable only at the option of the government (which fortunately for investors facing rising rates, have by now been fully redeemed)

A Solution - Guggenheim BulletShares

Guggenheim, recognizing that fixed-income can't be for real without genuine maturity dates, designed a series of funds (branded BulletShares) designed "to combine the best aspects of owning an individual bond and the best aspects of owning a bond fund" according to Bill Belden, Guggenheim's Managing Director for ETF Development.

For an example of how this works, consider the Guggenheim BulletShares 2020 Corporate Bond ETF ($BSCK), five years from now. As 2020 approaches, the typical fixed income fund will sell bonds and buy new ones in such a way that it keeps its target five-year maturity. Guggenheim doesn't do that. It continues to hold and as individual bonds mature, the ETF will get the cash from the issuers and accumulate the proceeds in a cash or near-cash account; at the end of the year 2020, when all the bonds are gone, the cash will be paid to $BSCK shareholders. The fund will then vaporize into the ethers (in legal terms, liquidate).

This is not a risk-free investment. Like $LQD, $BSCK assumes credit risk, but from the strongest ("investment grade") corporate borrowers. Also, as Belden points out, there is secondary-market interest-rate risk. $BSCK and its BulletShares peers will rise and fall with the ebb and flow of interest rates. Payment at 100 cents to the dollar (assuming no credit defaults) requires holding to maturity, as would be the case with any bond. The difference is that however badly interest rates may move against bondholders, $BSCK shareholders know they'll be able to cash out and be whole at the end of 2020. Shareholders of $LQD can only cash out by selling in the secondary market and accepting their losses.

Put another way, rising $BSCK through wild interest-rate swings is like being in an airplane that flies through turbulence but ultimately lands safely and calmly. Being in $LQD is like being on a turbulent flight that stays turbulent and never lands.

Figure 1 compares price histories of $LQD with $BSCG, the BulletShares offering that matures at the end of 2016 (the one among the current roster that has the longest price history).

Figure 1

This interval, 6/7/12 through 11/9/15, was a good one for fixed income as the 10-year U.S. Treasury yield dropped from 3.17% to 2.36%. But compare the volatilities of the two ETFs.

  • Between 10/15/12 and 9/4/13, the 10-year Treasury yield rose from 1.70% to 2.90%, $BSCG's principal value shed 1.3%. At the same time, $LQD plummeted 9.3%, a huge drop for a fixed-income security, especially in such a short time frame
  • More recently, from 1/30/15 through 7/1/15, the 10-year Treasury rose from 1.68% to 2.36%. $BSCG hardly moved (up 0.2%), but $LQD shed 7.2% of its principal value.

Some Essential Bond Basics

Looking ahead, we know $BSCG will need to gradually fall about 10% by the end of 2016 in order to mature at 100 cents on the dollar. But this isn't the same as a 10% loss in a stock, or even a 10% loss in $LQD. The bond market is structurally different from the stock market.

The reason why one has to take the loss in $BSCG is because the market always insists that the yield of a bond (the contractually-fixed interest payment divided by the market value) be in line with current market conditions. When $BSCG was created in mid-2010, the 10-year treasury yielded 3.17% (and corporates were, as usual, higher). That's excessive by today's standards, so the market compensates by forcing buyers of those bonds pay premium prices which, when compared to the interest payments, would result in yields that make sense in today's market conditions.

Therefore, the impending loss on $BSCG (the evaporation of the premium), is offset by continuing receipt of monthly fund dividends that would, if not for the premium, be excessive by today's standards because they were established based on 2010 market conditions.

If this sounds a bit complicated, focus on "yield to maturity" a calculation that is based on dollar-level of interest payments, the current value of the principal, and the gains or losses that will need to occur in order to get the principal to par (100 cents on the dollar) by the maturity date. The yield to maturity for $BSCG is 0.96%, which is reasonable for short-term corporates that mature in just about a year.

How does $LQD fare in a look-ahead to the end of 2016? I have no idea. Nothing said in the last paragraph has any relevance because there is no maturity date to anchor a yield to maturity computation (again, any yield to maturity you might see in iShares literature is nothing more than a marketing bullet point; to make it real, iShares would have to cash the bonds in and pay the proceeds to you, which is not going to happen).

Should We Fear Complexity?

I understand that the above discussion of $BSCG might be something of a head-scratcher for many. And certainly in light of 2008, we should all have learned to clutch or wallets and run fast when people start talking about anything that remotely resembles higher mathematics.

Actually, though, if any of this seems strange, it's because the overwhelming bulk of financial-media rhetoric has been oriented toward stocks. By fixed income standards, the above discussion is actually quite elementary. In this world, duration and yield to maturity are as simplistic as PE and Price-to-Book are for equity investors.

$BSCG represents the traditional, old fashioned, way to play fixed income. It's the $LQDs of the world that are newfangled and complex; the result of quants gone wild.

The Bond Ladder

Guggenheim's setup (it doesn't have just one BulletShares offering; they presently have one investment-grade corporate fund with maturities set for each year from 2016 through 2024) empowers anybody to engage in laddering, a well-recognized and quite effective fixed-income portfolio management technique, one that's especially useful if we are worried about rising interest rates but don't want to sit in cash for who knows how long waiting for better buying opportunities.

A bond ladder is a diversified portfolio of bonds spread among a sequence of maturity dates. Here's an example of what such a portfolio can look like with Guggenheim BulletShares ETFs:

Table 1 - Laddered Investment Grade Fixed Income ETF Portfolio

Ticker

Year of Maturity

30-Day

SEC Yield %

Effective

Duration Yrs.

% of

Portfolio

$BSCG

2016

0.67

0.59

12

$BSCH

2017

1.23

1.60

11

$BSCI

2018

1.65

2.40

11

$BSCJ

2019

2.05

3.24

11

$BSCK

2020

2.45

4.14

11

$BSCL

2021

2.87

4.95

11

$BSCM

2022

3.24

5.82

11

$BSCN

2023

3.27

6.47

11

$BSCO

2024

3.52

7.17

11

(Disclosure: I am long all of these ETFs in these proportions; data is as of 11/6/15 and is from Guggenheim's on-line bond-laddering tool.

Here's how the ladder metaphor works: When $BSCG liquidates at the end of 2016, I'll use that money to invest in a new not-yet-created BulletShares ETF that matures in 2025. When $BSCH liquidates at the end of 2017, I'll reinvest those proceeds in a to-be formed BulletShares ETF with a defined 2026 maturity, and so on and so forth. I continually climb the ladder of maturity.

So what if interest jump suddenly and vigorously?

Being human, I'll kick myself for not having stayed in cash for however long it took for that to happen and for having passed up an opportunity to begin with a higher set of yields. But that would just be an emotional thing, analogous to the holder of a diversified equity portfolio regretting not having taken a 100% stake in the stock that turned out to have performed best.

Realistically, I'll cope in a constructive way. I won't suffer any loss on $BSCG because that's going to mature at 100 cents on the dollar.

  • I'll have modest paper losses for a while on $BSCH, but it won't a big deal. Regardless of what will be happening with interest rates, this ETF is moving toward its prescribed landing pattern; its price is getting ready to position for its not-so-distant maturity. I'll have to live with more on-paper volatility with the out-year funds, $BSCN and $BSCO. But they only combine for 22% of the portfolio.
  • Moreover, 12% of the portfolio, proceeds from $BSCG, will be invested at the highest yield, the one on the new 2025 offering, and another 11% will shortly thereafter be invested at the higher 2026 rate, again at 100 cents on the dollar in both cases. Hence laddering to control interest-rate is roughly analogous to a program of successfully averaging down on losing positions in an equity portfolio.

Table 2 compares summary data for the Guggenheim bond ladder and $LQD.

Table 2 - Ladder vs. $LQD

 

Guggenheim

Ladder

$LQD

30-Day SEC Yield

2.31%

3.51%

Avg. Maturity

2016-24

Never

Effective Duration

4.01 yrs.

8.03 yrs.

I probably know what you're thinking! Yield. Look how much I'm sacrificing. But notice the durations (a key measure of fixed-income risk). I'm cutting my interest-rate risk in half for starters but in reality, by much more because I have maturity dates while $LQD doesn't (in other words, the Ladder's duration statistic is a genuine number; that's not so for the $LQD duration).

Recall, too, that my ladder is very conservative; I start getting money back in 2016. If I really want to push yield up toward $LQD levels, I can.

Table 3 - More Aggressive Ladder

Ticker

Year of Maturity

30-Day

SEC Yield %

Effective

Duration Yrs.

% of

Portfolio

$BSCL

2021

2.87

4.95

25

$BSCM

2022

3.24

5.82

25

$BSCN

2023

3.27

6.47

25

$BSCO

2024

3.52

7.17

25

Table 4 - A More Aggressive Ladder vs. $LQD

 

More Aggressive

Guggenheim

Ladder

$LQD

30-Day SEC Yield

3.23%

3.51%

Avg. Maturity

2021-24

Never

Effective Duration

6.10 yrs.

8.03 yrs.

If I want to max out on yield and bypass the ladder, I can go all in on $BSCO. Now, the yield would essentially match that offered by $LQD. But $BSCO's legitimate duration would still be a year less than $LQD's make-believe duration; and $LQD still would from a specific maturity date.

Price versus Total Return

The comparison data discussed above is price only, not total return (i.e. it does not adjust for dividends). That is a topic for another day, one that will necessarily involve reinvestment assumptions.

For now, though, I recognize that in the world of guru-speak, discussion should be all total return all the time. Having managed a high-yield ("junk") bond fund in the 1980s and having experienced the bottom dropping out of the market as well as skimpy call screening that allowed pretty much any shareholder who wanted to speak to me to get through (not to mention a supervisor who once said to me after a bond defaulted pulling the fund's NAV lower "Great! Yield is higher, shareholders will love it"), there is no question in my mind that price alone matters - a lot. Investors who don't believe it at first seem to quickly come around when their statements balances show losses.

Disclosure: I am/we are long BSCG, BSCH, BSCI, BSCJ, BSCK, BSCL, BSCM, BSCN, BSCO.