(Dow Jones) One of the exchange-traded fund industry's latest innovations aims to answer a long-standing criticism of bond mutual funds: that these investments never mature and so investors can't lock in attractive yields as they can with individual bonds.
Two ETF providers, BlackRock Inc.'s iShares unit and Guggenheim Partners LLC, have begun offering "end-date" or "bullet" bond ETFs in the past year. The new funds hold a portfolio of bonds all maturing in the same year.
Unlike traditional bond funds, which continually roll holdings over, they are designed to terminate when those bonds' principal is returned. That means investors in the new bond ETFs, like individual bond holders, should be able to secure yields at the time they buy.
Many fixed-income investors hold bonds simply to smooth the volatility of a portfolio of long-term stock holdings. For them, the new funds' extra sense of security won't matter. But for others, perhaps facing a specific future expenditure like college tuition, knowing just how much money their investment will earn could make planning easier.
"It's a nice half-step between owning a straight bond and a bond fund," says Jim Heitman, a financial planner in Alta Loma, Calif. He has started using the funds with smaller investors with $150,000 or so to put in fixed income. For that type of investor, buying individual bonds with high face values and costly trading spreads could be treacherous.
By pooling money from investors, the funds acquire a large portfolio of bonds that mature at similar times, often within a few months of one another. Owning a large portfolio of similar but not identical bonds provides a big advantage in terms of diversification, but it also adds complexity.
The new bond ETFs should indeed allow investors to fix a certain yield at the time they buy--that is, to gauge the total amount of money they will receive in the target year, counting regular distributions that are paid each month and the final distribution when the fund liquidates. But because fund investors can cash in and out, the complexion of the funds' investment portfolios can change over time, and the breakdown between these two sources of investment return can shift.
For instance, if interest rates fall, funds could make smaller regular distributions, but would make up the difference with a larger payout at the end. If interest rates rise, the opposite will happen.
"If you are spending the interest and anticipating you'll get all (the original investment) back, that's not necessarily going to happen" with the ETF, says Ben Birken, a Chapel Hill, N.C., advisor. He has examined the bond funds but so far isn't recommending them to clients.
Another wrinkle: Because the ETFs hold dozens of bonds, not all will mature on the same date in the target year. When bonds with the earliest maturities fall due, the funds re-invest this principal in cash-like securities until the funds terminate and hand the money back to investors. Since cash yields are unpredictable, that means the yield investors lock in when they buy the ETFs won't be exact.