Regular readers know that I have been managing my retirement investments with an increasingly risk-averse attitude, particularly as applied to my equity allocations. On the other hand, I think I need to be more strategic in managing my fixed-income investments. My concern arises from the anticipated increase in interest rates that will probably kick-in sometime next year. After some study, I am considering moving some of my retirement nest egg into one or more defined maturity bond funds or ETFs. If you have never heard of these, join the club. I knew nothing about them until last month.
The problems with the individual bond strategy include: (a) the high initial cost of constructing an effective bond ladder; (b) lack of transparent bond pricing on the secondary market which can lead to unfairness to the purchaser; and (c) increased default risk.
I own individual I-Bonds and TIPS purchased directly at auction from the U.S. Treasury. However, because of problems (a)-(c), I do not own any individual corporate or municipal bonds.
The conventional bond fund strategy takes care of problems (a)-(c) but introduces the problem of interest rate risk. The market value of a bond paying a fixed interest rate fluctuates inversely with changes in market interest rates. These market interest rates are ultimately determined by the Fed. Thus, if you are a retirement investor with a significant position in a conventional bond mutual fund, a significant increase in interest rates can really tank the value of your fund shares. This is not a problem with individual bonds that are held to maturity.
This is where defined maturity bond funds can be helpful. Like the more ubiquitous target date retirement funds (which I do not like), defined maturity bond funds are constructed to terminate on a pre-determined fixed date in the future. Accordingly, the fund manager buys only bonds that are due to mature near the termination date. As the termination date approaches, the maturing bonds are turned into cash.
At termination, the entire fund is liquidated and funds are returned to the fund investors. If all goes according to plan, investors will receive their respective share of the face value of the bonds that were cashed plus any accrued interest that either accumulated separately and/or that was added to the bond principal. This means that the investor will not experience any losses associated with increases in interest rates. Also, many of the funds pay periodic interest to the investors so you can use it as a source of retirement income if you are retired or to enhance your nest egg if you are still in the accumulation phase.
So far, the big players in defined maturity bond fonds and ETFs appear to be Guggenheim Bulletshares ETFs and iShares iBonds ETFs. The current Guggenheim corporate bond products have maturities ranging from 2014 through 2022. The iShares iBond ETFs have maturities from 2015 to 2023. Both corporate and municipal funds are offered but since I will be holding these inside my 401k plan, there is no benefit that I can see to owning a muni fund.
The iShares products have significantly lower expense ratios so that’s what I am leaning toward.
When considering a purchase of a defined maturity bond fund, you should also evaluate at least the following: (a) the maturity date (i.e., when do you expect to need the money and/or when will you want to reinvest in a different interest rate environment); (b) the share price as a premium above or discount below the NAV share price; and (c) the distribution yield or rate (annual income distributions as a percentage of your share purchase price). The current distribution yields for short duration defined maturity corporate bond funds range from less than 1% to 4% or more for high yield funds that hold riskier corporate bonds.
Both the Guggenheim and iShares site make it easy to calculate a “Net Acquisition Yield” (estimated yield to maturity) based on your anticipated per share purchase cost, the NAV of the fund, and after deducting expenses.
What are your thoughts on owning defined maturity bond funds as a retirement investment?