Build Your Own Bond Ladder With ETFs

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  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.

In the past few months, credit spreads have tightened as the economy appears to be improving. The current high-yield credit spread is about 6.0% when using the Merrill Lynch High Yield Master II Index. The Merrill Lynch index is used because it has data going back to 1996, making historical comparisons more valid. To put things in perspective, the average credit spread is 6.0%. The minimum spread was 2.4%, posted in June 2007. The maximum was 21.8%, posted in December 2008.
If you're considering high-yield bonds as a replacement for another fixed-income sector, exercise caution with new investments right now. The current economic situation is improving, but high-yield is trading at its long-term average credit spread. It is no longer the value it was just a few months ago.

Portfolio Construction
BSJF seeks to replicate before fees and expenses the BulletShares USD High Yield Corporate Bond 2015 Index. The index is designed to represent the performance of a held-to-maturity portfolio of U.S.-dollar-denominated high-yield corporate bonds with effective maturities in 2015. The fund will terminate on Dec. 31, 2015, and will make a cash distribution to current shareholders of its net assets. As bonds mature in the final six months of operation, the fund's portfolio will transition maturing securities to cash.

The ETF currently has 119 holdings, which is only slightly less than the index's 146 holdings. The average credit quality of the underlying holdings is B, and the average duration is 1.8 years.

Fees
This fund charges a 0.42% management fee. While this is still quite a bit higher than what investors would pay for an aggregate bond index, it is cheap compared with active high-yield bond funds. BSJF has more than $150 million in assets and has an average daily volume of 43,000 shares. Liquidity is adequate, but, because the investor base is more buy and hold, it will never have the high volumes of the more popular traditional high-yield bond ETFs. Limit orders should always be used when trading this ETF.

Alternatives
Guggenheim has a full suite of BulletShares ETFs with maturities ranging from 2012 to 2018. The various maturities could be used together to create a bond ladder.
PIMCO 0-5 Year High Yield Corporate Bond Index ETF (HYS) is the closest direct competitor to BSJF. With an expense ratio of 0.55%, HYS offers a similar yield and duration to BSJF. HYS is a perpetual fund that will reinvest maturing securities into new bonds.

 

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Disclosure: Morningstar, Inc., receives fees for licensing its indexes to ETF/ETN providers. These fees are mainly based on fund assets under management. BlackRock Asset Management; First Asset; First Trust; Invesco; Merrill Lynch; Northern Trust; Scottrade; and Van Eck currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.