An Overlooked Bond Vehicle: Defined-Maturity Bond ETFs

Fixed income ETFs

Fixed income ETFs offer a welcome alternative because, like mutual funds, the ETFs may offer diversified exposure to a basket of bonds in a single transaction, but unlike mutual funds, ETFs trade on major stock exchanges, affording the added benefits of intra-day pricing and trading flexibility. They also offer greater transparency of holdings, potential tax efficiencies, and generally lower expenses than both mutual funds and individual bonds – not to mention the instant diversification.

For these reasons, fixed income ETFs have become the investment vehicle of choice for many investors.

Exhibit 1: Fixed income ETF growth

Exchange-traded funds have however never quite been a perfect fit for the bond market. In fact, some of the main selling points of ETFs — real-time pricing, instant liquidity and the ability to trade at a low cost — run counter to some of the core tenets of traditional fixed-income investing.

The buy-and-hold bond investor types don’t need to know precisely where their portfolio is trading at any given time, nor do they have much reason to liquidate or trade frequently.

Despite their popularity, however, fixed income ETFs have traditionally not allowed investors to construct laddered portfolios or target specific bond maturities. That changed with the advent of defined maturity bond ETFs, like Invesco’s BulletShares and BlackRock’s iBonds. They are fixed-income ETFs that actually look and act like bonds.

The pitch is so straightforward it’s a bit surprising that the funds still remain relative unknowns. Invesco and BlackRock each have for example investment-grade corporate-bond ETFs with maturities from 2019 through 2028 — and in each of those funds, they buy only bonds with matching due dates.

The idea is mainly that investors will construct a “ladder” by spreading their money across each of the funds, which will pay steady interest and ultimately return the net asset value. This is one of the most classic bond-buying strategies because individuals can reinvest principal in longer-dated debt if interest rates increase or pocket the funds and go elsewhere if yields dip too low.

The estimated yield at the beginning is the total return you get at the end of it. This strikes at the core of what long-term, fixed-income investing is all about.

Invesco also offers high-yield and emerging-market debt defined maturity ETFs, while BlackRock has municipal-bond funds besides the aforementioned corporate bonds.

A comparison between different bond investment options

Let’s make a pairwise comparison between individual bonds, bond mutual funds, bond ETF’s and defined maturity bond ETFs.

Bond mutual fund versus individual bonds

Conventional bond funds don’t have maturity dates, meaning their prices can get trashed when interest rates are rising. With individual bonds, you mitigate the risk by just holding on to a bond until maturity, when you’ll be paid its full face value barring a bankruptcy or other detrimental event.

For many people, managing a portfolio of individual bonds is no picnic, however. Bond mutual funds offer diversified exposure to a basket of bonds in a single transaction. Traditional funds usually hold a diversified portfolio of bonds and have a portfolio manager who oversees and manages the fund. The one downside is that because traditional funds don’t have maturity dates, the investor would need to sell a portion of the fund if they wanted to take money out of the strategy.

Exhibit 2: Bond mutual fund versus individual bonds

ETF vs. individual bonds

ETFs have revolutionized the ease with which people can invest in the markets, but passive ETFs with perpetual duration that are exposed to the most-indebted borrowers can’t quite mimic that traditional role of fixed income. Those ETFs lack the customized maturity profile and the final distribution at maturity.

Like bond mutual funds, bond ETFs also offer a diversified exposure to a basket of bonds in a single transaction. While liquidity can be an issue with individual bonds, this is not an issue for bond ETFs.

Exhibit 3: ETF vs. individual bonds

Bond mutual funds versus bond ETFs

There are not many differences between bond mutual funds and ETFs. ETFs offer intraday liquidity and more mutual funds are actively managed compared to ETFs.

Exhibit 4: Bond mutual funds versus bond ETFs

Defined maturity bond ETFs vs individual bonds

The two advantages of individual bonds that are lacking in bond mutual funds and ETFs – the customized maturity profile and the final distribution at maturity, are available with defined maturity bond ETFs. They are ETFs with specific maturity dates, which hold each bond until they expire and distribute the proceeds once all bonds have matured, as is the case with individual bonds.

Defined maturity bond ETFs offer also the advantage of cost effectiveness.

Exhibit 5: Defined maturity bond ETFs vs individual bonds

Defined maturity bond ETFs vs traditional bond ETFs

Defined maturity bond ETFs do have the two advantages of individual bonds that are lacking in bond mutual funds and ETFs:

the customized maturity profile and the final distribution at maturity.

Furthermore, they offer all the advantages of “normal” ETFs like e.g. daily liquidity.

Exhibit 6: Defined maturity bond ETFs vs traditional bond ETFs

Overview

Exhibit 7 summarizes the main characteristics of the different bond vehicles.

Exhibit 7: Overview

Bond laddering

In today’s uncertain market, defined maturity bond ETFs’ most compelling application may be laddering.

Laddering with defined maturity ETFs provides a level of efficiency, cost effectiveness, and flexibility that was largely unavailable through individual bonds.

Bond laddering is a popular strategy among investors seeking steady returns and income, particularly when interest rate conditions are uncertain. Laddering is the practice of buying bonds that mature in consecutive calendar years, and then reinvesting the proceeds from maturing principal into new bonds that extend the ladder out another year.

Defined-maturity bond ETFs make building bond ladders more efficient by combining the control of investing in individual bonds with the convenience and diversification of an ETF. For example, an investor could build a five-year ladder by purchasing five defined-maturity ETFs, thereby gaining exposure to hundreds of underlying bonds with known maturity dates, monthly income stream potential, and an overall experience that’s vastly simpler than do-it-yourself.

To help manage interest rate risk, fixed income investors frequently construct laddered bond portfolios — i.e., portfolios of individual bonds that have varying terms to maturity. As shorter-dated bonds mature, the proceeds are rolled over and invested into bonds with longer-dated maturities. Investing across a range of maturities prevents investors from having to make a specific call on the yield curve, as this happens automatically in conjunction with the maturity of the portfolio.

Yet, creating ladders with individual bonds can present a number of challenges, including limited bond availability, liquidity and cost constraints, concentrated bond exposure, and credit research on individual companies and securities. The availability of individual bonds with the investor’s target maturities can be lacking. There may be liquidity constraints and limited trading flexibility with individual bonds. Finally, cost can be an issue as individual bonds may have high minimum purchases of $10,000 or more.

And over time, products that support laddering give investors the potential to benefit from “rolling down the yield curve” and taking advantage of both income and price changes. An example of the laddering products is BulletShares ETFs. This is a preferred strategy when the yield curve is upward sloping or steep. Under this scenario, an investor would purchase a bond at the top of the steepest part of the yield curve and hold the bond long enough until it reaches a lower yielding part of the curve. The objective is to benefit from built-in appreciation that occurs as a normally higher interest rate bond becomes a valuable shorter-term bond.

Exhibit 8: Bond ladder example

Defined maturity bond ETF Bond ladder examples

The following is an extensive list of the defined maturity bond ETFs available. Blackrock offers municipal and investment grade corporate defined maturity bond ETFs. While Invesco also offers investment grade corporate defined maturity bond ETFs and high yield and emerging market debt defined maturity bond ETFs.

Exhibit 9: List of available defined maturity bond ETFs

For our example we use maturities ranging from 2020 to 2026 and we equal weight the different maturities. Only for the emerging market debt ladder we use maturities from 2021 to 2024 (because only those maturities are available).

How e.g. the iBonds investment grade corporate bond ladder looks like can be seen in exhibit 10 below.

Exhibit 10: Investment grade corporate bond ladder

It will not surprise you the curve is rather flat.

An overview of the five different bond ladders can be found in exhibit 11. Note that it is perfectly possible to mix the different bond types if you want. You’re also free to deviate from the equal weighting we used in this example.

The first thing we notice is that the IG corporate bond ladders of Blackrock and Invesco are very similar.

The second conclusion we can draw is that the YTM is fairly low for the different ladders, with the exception of the high yield ladder. This should not come as a surprise given current low interest rates.

Exhibit 11: Bond ladder overview

But the different examples do demonstrate the high flexibility offered by defined maturity bond ETFs.

Conclusion

For fixed income investors, defined maturity ETFs offer a range of potential benefits, including flexibility, transparency, diversification, and liquidity.

More importantly, these innovative vehicles allow investors to implement a range of fixed income portfolio strategies that until now may have been too complex and/or costly. Whether investors are seeking to generate current income, reduce interest rate risk, manage cash flow needs, or meet a range of other objectives, defined maturity fixed income ETFs may offer a low-cost solution.