Maturity ETFs can make laddering simpler and more diversified. For example, instead of buying a single five-year bond and holding it to maturity, you could build a five-year ladder with bonds that mature each June for the next five years. When one bond matures, you can purchase a new five-year bond with the proceeds (see illustration). The draw for investors is that it provides stable cash flow: each year, you have new money to reinvest from a maturing bond as well as the semi-annual coupon payments from the bonds.
The ability to manage exposures on a yearly basis can be especially beneficial in a rising rate environment. As interest rates change over the period, each bond in the ladder will have a similar total return as the average yield at the time of purchase. By locking in a yield at the beginning, the ladder helps insulate the bond buyer from price losses if the investor holds to maturity.
As with a lot of things, however, this strategy is simple in theory but more complicated in practice. For many people, managing a portfolio of individual bonds is no picnic.
Small fish in a big sea
The first challenge is selecting the bonds. Should you go only to an issuer that you know? The highest-yielding bond? Or the one with the best credit rating? Researching the credit quality of the issuer requires access to information and the know-how to evaluate relative value between bonds. Even for experienced investors, this can be daunting.
Once you’ve decided to purchase a bond, transaction costs can be high. The average retail investor pays about 0.90% in bid-offer spread on municipal and 0.64% on corporate bonds, according to S&P1. Many bonds have minimum bond sizes to buy and trade. If you don’t have a large amount of money to invest, the ability to diversify and spread credit risk across multiple issuers can be difficult. As a result, you might end up with a concentrated portfolio from just a handful of bond issuers.
Finally, liquidity, or the ability to convert the bond into cash, can be challenging for individual securities. If you want to sell a bond prior to maturity, you’ll need to find another buyer in the over-the-counter bond market, which might take time. And if your bond has a call feature, you could get repaid early if the issuer decides to refinance its debt. In that case, you’re facing reinvestment at lower yields.
Laddering with defined-maturity bond ETFs
Many investors use mutual funds and exchange traded funds (ETFs) to overcome some of these hurdles. 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.
Defined-maturity bond ETFs, such as iShares iBonds, can help build efficient bond ladders by combining the reinvestment control of individual bonds with the convenience of an ETF. In a single transaction, investors gain access to:
- A known maturity: All the bonds mature during the calendar year in the fund’s name. For example, the bonds in the iShares iBonds Dec 2021 Term Corporate ETF (IBDM) mature between January 1st and December 1, 2021. When the last bond matures, the fund returns its final net asset value to shareholders in cash.
- Monthly distributions: Defined-maturity bond funds make monthly distributions of income, which can be smoother than the lumpy coupon payments of a bond ladder. Monthly distributions can be variable depending on changes in market yields and fund assets.
- Diversification: Each ETF holds hundreds of investment-grade bonds.
- Tradability: While individual bonds are traded in the over-the-counter bond market, defined-maturity ETFs can be traded throughout the day on the exchange at a known price.
- Low cost: ETFs may be more cost-efficient that buying a portfolio of over-the-counter bonds. For example, iShares municipal and corporate iBonds have management fees of 0.18% and 0.10%, respectively.
Going back to our example of the five-year bond ladder, an investor could purchase just five defined-maturity ETFs and gain exposure to hundreds of underlying bonds with known maturity dates, a monthly income stream—and an overall experience that’s vastly simpler than do-it-yourself.
Build on Insight, by BlackRock written by Karen Schenone, CFA
Investing involves risks, including possible loss of principal.
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Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
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There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.
The iShares® iBonds® will terminate in March, September or December of the year in each Fund’s name. An investment in the iShares® iBonds® ETFs (“Funds”) is not guaranteed, and an investor may experience losses, including near or at the termination date. Unlike a direct investment in a bond that has a level coupon payment and a fixed payment at maturity, the Fund(s) will make distributions of income that vary over time. In the final months of each Fund’s operation, as the bonds it holds mature, its portfolio will transition to cash and cash-like instruments. As a result, its yield will tend to move toward prevailing money market rates (or, in the case of the municipal iBonds, tax-exempt money market rates) and may be lower than the yields of the bonds previously held by the Fund and lower than prevailing yields in the bond market.
Following the Fund’s termination date, the Fund will distribute substantially all of its net assets, after deduction of any liabilities, to then-current investors without further notice and will no longer be listed or traded. The Funds’ distributions and liquidation proceeds are not predictable at the time of investment and the Funds do not seek to return any predetermined amount.
The rate of Fund distribution payments may adversely affect the tax characterization of an investor’s returns from an investment in the Fund relative to a direct investment in bonds. If the amount an investor receives as liquidation proceeds upon the Fund’s termination is higher or lower than the investor’s cost basis, the investor may experience a gain or loss for tax purposes.
Investment in the iShares® iBonds® Corporate ETFs is subject to the risks of the other funds and ETFs (underlying funds) in which it invests. The iShares® iBonds® Corporate ETFs will incur acquired fund fees and expenses associated with its investments in the underlying funds and additional fees associated with turnover in the underlying funds that are not included in the acquired fund fees and expenses.
Diversification and asset allocation may not protect against market risk or loss of principal.
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This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of May 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
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Karen Schenone is a Fixed Income Product Strategist within BlackRock’s Global Fixed Income Group focusing on iShares fixed income ETFs. She concentrates on supporting iShares clients, generating content on fixed income markets and ETFs, developing new fixed income iShares ETF strategies, and partnering with the iShares team on product delivery. She writes about fixed income ETFs and trends in that sector.