Target Maturity Bond Funds and ETFs

Bonds or bond funds? For anyone who has more than a slight interest in bonds, that’s a perennial question.

Money guru on TV Suze Orman says you should buy bonds not bond funds because a bond fund doesn’t have a set maturity date. When you sell from a bond fund, you can get back less than what you put in. There’s some truth to that but it’s largely false unless you are investing for a fixed time period in the near future and you will be liquidating all at once when that time comes.

A bond fund on the other hand offers diversification you can’t easily match with individual bonds. A bond fund holds many bonds. Unless you have a huge sum of money devoted to bonds, it’s not feasible to buy that many individual bonds.

As much a finance buff as I am, I have never bothered to buy individual bonds except Treasuries and TIPS. Suze Orman says something about buying high quality general obligation municipal bonds outside a retirement account. Wrong demographic. Buying individual municipal bonds is not for the faint of heart. Investors face lack of diversification, bad liquidity, and possibly high transaction cost. At a minimum, it requires a lot of knowledge and legwork to find the right issue and the right price.

What if you are investing for a fixed time period, for instance for a house down payment, college expenses for a child, or a balloon payment on a loan? Or if you are a retiree and you are following another money guru Ray Lucia’s Buckets of Money® approach and setting aside living expenses for the next five to seven years?

You can buy CDs or Treasuries, matching the maturities with when you will need the money. You can also buy an unusual type of bond funds: target maturity bond funds.

Like a regular bond fund, a target maturity bond fund also holds many bonds. You get diversification, liquidity, and low transaction cost. Unlike a regular fund which holds bonds maturing at different times, a target maturity bond fund holds bonds that mature around the same time. When the target date comes, the bonds mature; the fund liquidates and distributes the money to you. Although a target maturity bond fund doesn’t guarantee a liquidation value or interest payout, it behaves more like an individual bond than a regular bond fund.

There aren’t many target maturity bond funds in the market at this time. American Century offers three open-end funds investing in zero coupon Treasuries. All three funds have an expense ratio of 0.57%.

• American Century Target 2015 (BTFTX)
• American Century Target 2020 (BTTTX)
• American Century Target 2025 (BTTRX)

iShares offers six ETFs investing in AMT-free municipal bonds. From iShares website:

“The Fund will invest in AMT-Free, investment grade, noncallable national municipal bond debt. Each Fund will terminate on or about August 31 of the year in the Fund’s name.”

The expense ratio is 0.30% for all six ETFs.

• iShares 2014 AMT-Free Muni Term ETF (MUAC)
• iShares 2015 AMT-Free Muni Term ETF (MUAD)
• iShares 2016 AMT-Free Muni Term ETF (MUAE)
• iShares 2017 AMT-Free Muni Term ETF (MUAF)
• iShares 2018 AMT-Free Muni Term ETF (MUAG)

Although the yields look low, remember you don’t pay federal income tax on interest income from muni bonds.

Another ETF provider Guggenheim Funds also offers a series of target maturity ETFs that invest in investment grade corporate bonds maturing from 2014 to 2022. Those ETFs have an expense ratio of 0.24%.

The American Century open-end funds have been around for a long time. Because they invest in Treasuries, the diversification benefit isn’t so valuable. An individual investor can just buy a Treasury note or bond maturing in the target year.

The iShares and Guggenheim ETFs were started in 2010. They don’t have a large asset base yet. Trading volumes are still very low. The expense ratios aren’t too bad, but for some odd reasons they often trade at a premium to net asset value. In a low interest rate environment, that premium further eats away value from these ETFs.

Nevertheless, I see the target maturity bond funds and ETFs as a good tool for solving a real problem: investing in a diversified basket of bonds for a fixed period of time and liquidating all at once. They combine diversification with a set maturity date. Otherwise you get only one but not the other – bond funds give you diversification but no set maturity date; individual bonds give you a set maturity date but not enough diversification.

The iShares and Guggenheim ETFs trade at a premium to net asset value at low volume now, but that doesn’t always have to be the case. They are new. They can grow. Maybe they will inspire other companies to introduce some open-end target maturity bond funds, which won’t have these problems. Vanguard?

Until then, keep buying CDs if you are investing for a fixed time period in the near future and you will be liquidating all at once.