The writing has been on the wall for a while about rising interest rates. This year, we saw exactly what this move does to bond funds, as rates rise, the price of bonds fall and the value of bond funds fall with it. One way around this is to own individual bonds (I’ve highlighted others like floating rate bond funds). A target maturity bond ETF might be another option.
One of the benefits of owning an individual bond is the fact it has a maturity date. It’s an end date. The bond matures and you get your money back. That doesn’t exist with a bond fund. Of course, when you own individual bonds you lose the diversification a bond fund offers. But what if you could combine the two? Well, a target maturity bond ETF brings a maturity date to a diversified bond fund.
What Is It
A target maturity bond ETF holds a basket of bonds that mature in the same year. Once the bonds in the fund mature, the fund is closed, and you are paid out.
You might find a fund with a maturity date of 2016. In that case, the fund would own bonds maturing in 2016. At the end of that year, the fund is closed, you’re paid the face value of the bonds, and free to invest your money again.
The key is owning the fund until maturity. As long as you hold the fund till the maturity date, you lower your interest rate risk and the chance of losing money.
The big benefit of owning bonds is the ability to pick the maturity date. You buy the bond, it pays interest, and upon maturity you get your initial investment back. Sure, interest rates will bounce around between when you buy it and the bond maturing. The bond price will fluctuate as interest rates move, but two things won’t change, the rate you earn on bond and the principal amount you paid. Once you own the bond, you’re locked in at that price and rate.
A target maturity bond fund does the same thing. In effect, it offers you the benefits of owning individual bonds, with the diversification of a bond fund.
Still, bonds aren’t without risks. Default risk is lower thanks to the diversified nature of funds but it still exists.
You’ll deal with interest rate risk if you decide to sell the funds early. The point of a maturity date is to own the fund the entire time. Selling early could lead to losses. Especially if bond prices fall after you invest.
Lastly, liquidity risk is higher for these funds. If you do sell early, don’t expect to find a lot of buyers. These funds are built to be held until maturity. Based on that, there are a few clear-cut cases these ETFs would fit.
So what would you use a target maturity bond ETF for? The same reasons you would own individual bonds for starters or use short-term investments. It’s perfect for lump sum investing and it preserves capital first. Attach it to a financial event tied to a set date and you have a winner.
An easy example is college savings. Unless your kid fails a grade, you know when they will start and graduate from college. Owning bonds that mature over that four-year span gives you the cash needed to cover each year’s cost. In return you get the piece of mind knowing that you won’t lose money from a last-minute market decline or interest rate spike. In that case, a target maturity bond ETF would be the wise alternative.
A bond ladder is another option. A bond ladder is a collection of bonds with evenly staggered maturity dates. As a bond matures, the money is reinvested in a new bond at the next staggered date. This process helps lower interest rate risk by locking into a new rate every few years and works great in a rising rate environment.
Most indexed based bond funds have a built in ladder mechanism. Still, laddering these target maturity bond funds give more control over the short and mid-term periods with less risk of principal loss.
For now, your choices are limited to three types of funds: municipal bonds, corporate bonds, and high yield corporate bonds.
Municipal bonds bring the added benefit of being tax efficient. You don’t pay federal income tax on interest earned. The corporate bond funds hold investment grade bonds with a higher credit rating. The high yield corporate bonds have a riskier, lower credit rating.
There are three fund families offering these ETFs at the moment:
- iShares offers target maturity muni and corporate bond ETFs
- Fidelity offers target maturity muni bond ETFs
- Guggenheim offers target maturity corporate and high yield corporate bond ETFs
The maturities being offered only go out about ten years and are staggered at two-year intervals. For instance, you’ll see funds being offered for 2015, 2017, 2019, 2021, and 2023. That should give you an idea of the time frame available and the financial goals you can tie these target maturity ETFs too.