In part one of her series on rising rates, Karen explains how defined—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.
Chart for illustrative purposes only.
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.
Karen Schenone, CFA, is a Fixed Income Product Strategist within BlackRock’s Global Fixed Income Group and a regular contributor to The Blog.
1: Source: Unveiling the Hidden Costs of Retail Bond Buying & Selling. S&P Dow Jones, March 2018.
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