This past fall and winter I added some new investments to my retirement portfolio. The investments are known as target date bond exchange traded funds. Sometimes they are referred to as “target maturity” bond funds. This type of investment is new. The target date bond ETF category shows great promise for providing bond-like retirement income with little or no interest rate risk.
A first approach is to buy individual corporate bonds. The advantage to this approach is that if you hold the bond to maturity, you know in advance what you will be paid when the bond matures. However, to implement this strategy, you need the ability to put a large chunk of cash into one or more individual bonds. An investment of $25k may be needed just to get your foot in the door. You will likely be buying these corporate bonds on the secondary market. This means that the real bond pricing is not transparent to you. The commission paid to the seller is buried in the price and yield for the bond. There is also a small risk of default which is magnified if you own only a single bond issued by a single company.
A second approach to bond investing for retirement is to buy shares in a bond fund or bond ETF. Here, the pricing is more transparent but in exchange, you are assuming significant interest rate risk. Conventional bond funds and bond ETFs do not have maturity dates. Accordingly, the NAV (net asset value) of these funds will rise and fall with changes in market conditions and particularly with changes in interest rates. If you were to buy shares today, you can expect the values of those shares to fall when the Fed eventually causes interest rates to increase. If you need to sell shares to provide retirement income, you may be selling at a price that is significantly lower than what you paid.
This is where the target date bond ETF comes in. These funds own bonds that mature within a pre-defined time window, the “target date.” As the target date approaches, the bonds owned by the fund mature. The fund managers take the cash received from the maturing bonds and invest it in short term treasury bills or other cash account. At the target date, all of the bonds have been redeemed by the issuers, the fund terminates, and the shareholder are paid in full based on the values of their initial investments (assuming no significant defaults). Prior to termination of the fund, the shareholders receive income from the interest paid on the bonds owned by the fund.
Note that there is no interest rate or other market risk with a target date bond ETF as long as you are willing to hold the shares until the fund terminates.
Target date bond ETFs are an excellent tool for creating a bond ladder. You choose the years when you want your principal to be returned to you then purchase shares in a target date bond fund that will mature and terminate in each of those years. In the interim, you will receive regular distributions from the funds that you own prior to maturity.
To my knowledge, there are two main sources of target date bond ETFs: Blackrock iShares and Guggenheim Bulletshares. You should be able to purchase these through any brokerage account. There are target date bond ETFs that focus on investment grade corporate bonds, high yield (more risk) corporate bonds, and municipal bonds.
I bought shares in IBDA, a corporate bond ETF that matures in March 2016. This fund is inside my 401(k) brokerage account. For my taxable account, I purchased shares in IBME, a municipal bond ETF with a target date of September 2016. This provides tax free income to me.
Of course the income from these funds is not huge but is better than most bank accounts and CDs. The longer the maturity, the greater the distribution return. Right now, you can buy target date bond ETFs with maturity dates extending to 2025.
So, for the fixed income part of your retirement portfolio, you can consider target date or target maturity bond ETFs. When you buy, pay attention to (a) the expense ratio and (b) the premium/discount, which is the amount by which the fund is trading either above or below the NAV. Target date bond ETFs are subject to a wider bid-ask spread because they are not heavily traded, as you would expect.
Good luck and safe investing!