Outside of U.S. Treasurys, the bond market is no place for the individual investor to transact directly. That’s because the bond market is much larger and much less liquid than the stock market. Bonds trade over the counter, encouraging wide bid-ask spreads.
According to a May 2017 article in The Economist, the corporate bond market is around $50 trillion. While companies may issue common stock and a few different denominations of preferreds, they may offer dozens of different denominations of bonds, differing in maturity, coupon, issue size and degree of seniority. And 90% of all corporate bonds trade fewer than five times per year. Given the high number of issues and the light amount of trading, bid-ask spreads can be 58 basis points for purchases and 101 basis points for sales by dealers in corporate bonds for trade sizes less than $50,000, according to Interactive Data Corporation. The spreads get wider at lower dollar values and narrower at higher dollar values. In addition to the wide spreads, investors face broker markups or commissions.
This makes the creation of bond ladders a difficult and pricey proposition for many investors and their financial advisors. And that’s unfortunate because ladders—which are portfolios of bonds ranging from short term to long term, with staggered maturities of, say, a year or two—can be helpful in coordinating payments with an investor’s obligations and hedging against interest rate risk. The short-maturity bonds deliver cash soon, and the proceeds from their maturities can be reinvested at higher rates where they are not used to meet obligations, and this can help a bond investor benefit from interest rate hikes with at least part of a bond allocation.
But one problem with ladders is that those composed of junk bonds can impose undue credit risk on investors. A ladder typically has only one bond at a particular maturity acting as one of its rungs, and most investors and advisors would be hard-pressed to commit even 5% of a portfolio to a single junk bond.
In order to remedy the problems of bid-ask spreads, transaction fees and concentration risk, fund companies such as BlackRock’s iShares unit, Guggenheim and Invesco PowerShares have devised fixed-term exchange-traded funds, also known as “defined maturity bond funds.” Fixed-term ETFs have maturity dates just like bonds, but are made up of many bonds maturing in a particular year, giving investors diversification for one particular rung of a ladder. The idea is for investors to get better pricing on bond trades and more diversification than they otherwise could with a bond ladder by using funds with maturity dates—not individual bonds—for each rung of the ladder.
iShares, for example, has 17 defined maturity bond funds. Ten of them are corporate bond funds ranging in maturity dates from 2017 to 2026. The other seven are municipal funds ranging in date from 2017 to 2023. The corporate bond funds hold investment-grade bonds, but they all have a healthy slug—between 40% and 60%—in “BBB”-rated bonds, which is the last rung of investment grade.
An Imperfect Solution
A glance at the iShares iBonds Dec 2017 Term Corporate ETF (IBDJ), however, demonstrates one of the problems of defined maturity bond funds—22% of it is in a money market fund because the bonds have already matured or been called before the fund’s maturity date. That means investors aren’t getting the total benefit of owning a fully invested corporate bond portfolio until the fund’s maturity date. The 2017 fund’s distribution yield is 1.08% while its sibling, the iShares iBonds Dec 2018 Term Corporate ETF (IBDH), has a yield of 1.58%. The latter fund has only 2.1% of its portfolio in a money market fund. Investors in the 2017 fund could move into the 2018 fund in order to capture more yield before reaching their presumed 2017 goal, but in doing so they would then incur at least a small amount of interest rate risk and the possibility that their principal could decline before they met their 2017 obligation.
The Guggenheim BulletShares 2017 Corporate Bond ETF (BSCH) has only 8% of its portfolio in a money market fund (as of March). However, that low figure may be due to some luck in the maturity dates. In any case, the fund has nearly the same distribution yield—1.09%—as its iShares counterpart, and it also has nearly 2.5 times the expense ratio at 0.24%. The expense ratios of the iShares corporate defined maturity bond funds all clock in at a pleasingly low 0.10% Guggenheim also has a suite of high-yield corporate bond funds, for which the defined maturity bond fund structure would seem most appropriate given the imprudence of holding a single junk bond for a particular maturity date in a bond ladder. The Guggenheim suite goes from 2017 to 2024, and the expense ratios of the funds are either 0.42% or 0.43%. In comparison, some ordinary high-yield bond ETFs cost around 0.50%, while the SPDR Bloomberg Barclays High Yield Bond ETF (JNK) costs 0.40%.