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Build Your Own Bond Ladder With ETFs

Target-maturity bond ETFs are an interesting option for fixed-income investors.

Timothy Strauts, 05/11/2012

An ongoing debate for many years has been over what is better for investors, individual bonds or bond mutual funds? The decision usually comes down to the investment's goals. If you want complete control of your portfolio's maturity, yield, and credit quality, then individual bonds are for you. If you want broad diversification, liquidity, and consistent portfolio characteristics, then bond funds are the answer. Target-maturity exchange-traded funds from Guggenheim seek to bridge these differences into a product that can appeal to both types of investors.

Target-maturity bond ETFs are very similar to regular bond ETFs except for a key difference. The bonds in a target-maturity fund all mature in the same year. In the maturity year, the fund will close and return all investment capital to shareholders just like an individual bond would. An investor can get the diversification and liquidity benefits of a fund and the return of principal of an individual bond. Target-maturity bond ETFs are the next evolution of fixed-income investing. Growth will be slow initially, but the new structure has too many advantages to not catch on with investors. Let's look at an example of a target-maturity ETF.

  - source: Morningstar Analysts

Target-Maturity High-Yield Bond Fund
We consider investing in high-yield corporate bonds to be similar to investing in the equities of companies with highly leveraged balance sheets. As such, an investment in Guggenheim BulletShares 2015 High Yield Corporate Bond BSJF should be viewed as a satellite holding, and a risky one at that.

Corporate bonds are denoted high-yield for the sole reason that firms issuing them are highly leveraged. Companies with this kind of leverage profile can get there either intentionally (because of a leveraged buyout, leveraged acquisition, or recapitalization) or unintentionally (because of a deterioration of the underlying business of an erstwhile investment-grade firm). Either way, the risk from leverage is the same, even if the businesses may be moving in different directions. With increased leverage comes the increased probability of default and bankruptcy. In the grand scheme of things, risk equals return, and the high yield of these bonds is designed to compensate investors for this risk.

Because high-yield bonds are a very illiquid asset class, one of the most efficient ways to own them is through a target-maturity ETF. A cost factor that is not discussed frequently is the extra trading costs that a typical bond ETF incurs selling bonds. For example, iShares iBoxx $ High Yield Corporate Bond HYG owns corporate bonds with a maturity between three and 15 years. When the maturity of a bond in the fund falls below three years, it is sold and the proceeds are reinvested in another bond within the target range. This constant selling of bonds creates additional expenses that reduce overall returns. The total cost of this selling is very hard to calculate, but estimates range between 0.20% and 0.60% per year depending on the liquidity of the underlying bonds. Target-maturity bond ETFs will not have this cost drag because they hold their bonds to maturity.

Fundamental View
The corporate high-yield bond market has recovered from its steep drop at the end of 2011. BSJF offers a 12-month yield of 4.75%. While not as lofty a yield as other high-yield ETFs, BSJF takes minimal interest-rate risk with a portfolio that will mature and return money to investors in 3.5 years. The high-risk nature of these securities means that defaults are still possible, and investors need to consider whether the high-yield bonds are worth the risk.

On a trailing 12-month basis, the current high-yield default rate is only 1.9%. This is a very low rate, and almost all of the defaults are occurring in the lowest-rated CCC bonds. For comparison, the default rate was 13% in 2009 in the aftermath of the financial crisis. BSJF has only 16% of its portfolio in bonds rated CCC, so it owns a lower percentage of CCC than many of the popular high-yield indexes.

Timothy Strauts is an ETF analyst at Morningstar

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