Target Date Bond ETFs: Best or Worst Fixed Income Funds?

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January 16, 2013 2:48pm NYSE:BSCB NYSE:BSCC

target-date1Eric Dutram: Often times, income seeking ETF investors are paralyzed by choice when it comes to fixed income investing. To make matters worse, we have had numerous bond ETFs filing and launches over the past few quarters suggesting that more are on the way as well.

However, thanks to the Fed’s policies, rates on all types of fixed income are nearing all-time lows. With the prospect of a bond bubble bursting, investors are starting to grow somewhat uneasy about investing in the space, even though it still does provide an outsized level of income to investors.

Given these circumstances, a bond ETF investor has to look at riskier propositions like bond funds with higher duration (i.e. a measure of interest rate risk) since bond funds targeting the higher end of the yield curve generally have higher rates of interest attached.

Still, bond ETF investing generally comes with one caveat; securities usually target a specific time frame and roll over continuously. In other words, there usually isn’t a maturity period in which a cash payment is delivered for these ETFs.

Investors who are looking for a way to play bonds in a more traditional way now have some decent options in the space. These securities, which offer up a payout at the end of the security’s maturity are known as Target Date Bond ETFs and these may be what some bond ETF investors have been waiting for.

The portfolios of these ETFs are basically comprised of bonds which 1) have similar residual maturity, 2) belong to the same issuer class (i.e. corporate, municipal) and 3) mature in the similar year, but not necessarily the same date. This means that these ETFs typically have a definite maturity in contrast to other bond ETFs like AGG or BND.

Thus, they have individual bond-like traits i.e. having a definite maturity under the wrapper of an ETF which enables buying and selling of these instruments in more efficient and cost effective ways.

However, it should be noted that it is not mandatory for an investor to hold these ETFs until maturity as the same trading rules that impact all other ETFs hit this corner of the market as well (see 3 Reasons to Consider the Crossover Bond ETF).

Investors have the option to either a) hold the ETFs until maturity, in which case the principal amount invested will be returned on the date of maturity plus regular coupon payments or, b) liquidate their positions before the maturity date if the need for cash arises, in which case they will be subject to receive payments equal to the current market price of the shares (which is subject to interest rate risk) times the number of shares bought plus any coupon due.

Like any other investment avenue, target bond ETFs have their own sets of pros and cons. While they are generally more inexpensive than their regular bond counterparts in terms of expense ratios due to their lower portfolio rebalancing and turnover, it is also true that they usually incur wider bid-ask spreads due to the low volumes triggered by the inactive trading thereby increasing the total cost of investments in them.

Also, if these ETFs are held until maturity, the effective annual yield on the invested amount for the entire holding period if adjusted for inflation turns may not be that robust. This can be especially true as we approach the redemption date of the ETF, since the bonds in their portfolio are also nearing maturity and more of the portfolio is shifting to cash.

However, these ETFs can be of interest to investors who wish to ride out the stock market volatility in times of severe uncertainty and at the same time ensure a steady stream of cash flow from their portfolio.

They can also be great picks for investors seeking to match up assets with liabilities, in order to have capital ready for a big purchase a few years out (see Comprehensive Guide to U.S. Junk Bond ETF Investing).

Presently, there are three series of target bond ETFs available to investors. These ETFs target the 1) Investment Grade Corporate Bonds—by Guggenheim, 2) Non-Investment grade corporate bonds—by Guggenheim and 3) AMT Free Municipal Bonds by iShares.

Below we have created three laddered model bond ETF portfolios based on ETFs by individual issuers, which investors can use to employ a bond laddering strategy using target date bond ETFs. The model portfolio assumes equal allocation to each ETF across a period of 5 years as well as a ‘hold till maturity’ strategy with roll over thereafter.

(All yields are trailing 12-month yields except when noted otherwise).

Model Portfolio 1 (Investment Grade Corporate Bonds by Guggenheim)

ETF Maturity (Year) Expense Ratio Yield
(BSCD) 2013 0.24% 1.36%
(BSCE) 2014 0.24% 1.71%
(BSCF) 2015 0.24% 2.14%
(BSCG) 2016 0.24% 2.38%
(BSCH) 2017 0.24% 2.69%
Average 0.24% 2.06%

Model Portfolio 2 (Non Investment Grade Corporate Bonds by Guggenheim)

ETF Maturity (Years) Expense Ratio Yield
(BSJD) 2013 0.42% 4.53%
(BSJE) 2014 0.42% 4.84%
(BSJF) 2015 0.42% 5.21%
(BSJG) 2016 0.42% 5.36%
(BSJH) 2017 0.42% 5.22%
Average 0.42% 5.03%

Note: Yield for BSJG and BSJH are SEC yields since these ETFs are less than a year old.

Model Portfolio 3 (AMT Free Municipal Bonds by iShares)

ETF Maturity (Years) Expense Ratio Yield
MUAB 2013 0.30% 0.80%
MUAC 2014 0.30% 0.82%
MUAD 2015 0.30% 1.24%
MUAE 2016 0.30% 1.51%
MUAF 2017 0.30% 1.66%
Average 0.30% 1.20%

Although the implied portfolio yield of these model portfolios do not seem very high, they arguably offer up a truer look at the bond market. As a result, any of the picks above could make for interesting satellite holdings or as an easy way to prepare for a big expense a few years down the road.

zacksWritten By Eric Dutram From Zacks Investment Research 

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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