Flow Charts: Where the ETF Money Went in March 2021
Unlike single bonds, most bond ETFs never mature
Perhaps one of the most overlooked differences between a single bond and a bond fund is the fact that most bond funds never mature. The individual bonds in a fund of course all have maturity dates, but as time goes on the portfolio manager usually replaces older bonds (with less time to maturity) with newer issues (and longer time to maturity), so that the overall average maturity of the fund stays fairly constant over time.
The popular iShares iBoxx Investment Grade Corporate Bond ETF (LQD), for example, has a weighted average maturity of 12.5 years, so in that aspect it resembles a single bond maturing in 2030. Five years from now, however, while the single bond will have 7.5 years remaining until maturity, LQD is likely to have a substantially different portfolio of bonds than it does today, probably still with an average maturity of around 12.5 years—maturing in 2035!
A single bond and bond fund that are similar to each other today are likely to perform quite differently going forward
As a result, a single bond and bond fund that are similar to each other today are likely to perform quite differently going forward. Those differences might be especially large if interest rates rise causing bond prices to fall, as many people expect.
Whereas a single bond’s price will fall in response to a rise in interest rates, this is only a temporary, unrealized loss for an investor who holds the bond to maturity. Baring a default, the investor will eventually realize the yield to maturity he or she calculated when the bond was purchased.
A bond fund however that constantly replaces bonds in its portfolio will end up selling some of those bonds at a lower prices, thus realizing a loss of capital and having diminished funds with which to purchase new bonds.
To alleviate this problem, several ETF issuers have created Target Date bond funds, consisting of bonds with similar maturities, segmented by year, that are actually held to maturity. When the last bond in the portfolio matures, all the cash in the fund is returned to shareholders and the fund liquidates.
A primary benefit of target date bond ETFs is to help insulate investors from rising interest rates
Although there are caveats we elaborated on a few months back, one of the primary benefits of target date bond ETFs is that they can help insulate investors from the impact of rising interest rates. As a result these funds are becoming increasingly popular with investors.
Competing product line-ups of the same credit quality and target dates from different issuers are just begging for comparison! We looked under the hood at two such product suites holding investment grade corporate debt: the Guggenheim BulletShares and the iShares iBond Term families of ETFs (Table 1). (Both issuers also have high yield versions not discussed here).
Table 1: Guggenheim and iShares Target Date Corporate Bond ETFs (Investment Grade)
| Target Date | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 |
| Guggenheim BulletShares | BSCH | BSCI | BSCJ | BSCK | BSCL | BSCM | BSCN | BSCO | BSCP | BSCQ |
| iShares iBond Term ETFs | IBDJ | IBDH | IBDK | IBDL | IBDM | IBDN | IBDO | IBDP | IBDQ | IBDR |
Source: www.etfresearchcenter.com
These funds have similar credit profiles to each other. All target date 2017-2021 funds have a median S&P rating of A-, while all funds with target dates between 2022 and 2026 have a median score one notch lower, at BBB+.
Naturally, investors will seek out the highest yields for a given amount of risk, so we looked at the yield-to-maturity (“YTM”) of each of these portfolios, comparing each Guggenheim fund to its iShares counterpart, based on our YTM calculations for each underlying bond in each of the portfolios. We found that for most but not all target dates the Guggenheim fund offered slightly higher yields, averaging 7 basis points across the range of target dates (Figure 1). We omitted the two target date funds for 2017 since a large portion of their portfolios has already matured and is being held in near-cash instruments.
| Figure 1: Yield to Maturity Comparison Guggenheim vs. iShares Target Date Funds |
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| Note: As of 8/21/17. Source: www.etfresearchcenter.com |
Does this mean that investors looking for a target date bond fund should go with the Guggenheim offering in most cases? Not necessarily. As usual, things get a bit more complicated than just headline metrics like yield-to-maturity.
Despite each of the Guggenheim funds having the same median credit rating as their iShares counterparts, in aggregate the Guggenheim funds are slightly more risky. Despite being investment grade now, a few of the bonds in the funds are bound to default as the years pass, and these defaults will eat into returns.
The ALTAR Score™ rating—our measure of an ETF’s overall investment merit—takes this into account by calculating an annual “default factor.” That is, the likely annual hit to shareholders from defaults, based on historical default and recovery rates for bonds of similar quality and maturity.
The differences are small to be sure, but because the underlying bonds in the Guggenheim funds are of slightly lower quality in aggregate, they could see slightly higher defaults going forward.
Accounting for both fund expenses and the “default factor” results in the opposite conclusion than had we considered YTM alone
The other factor to take into account when evaluating a fund versus the individual bonds in the fund is the fund’s expenses. Although we typically focus less on fund fees in our ETF analysis since differences in the underlying securities between two funds is likely to exert a larger impact on performance, in this instance with each target date portfolio being so similar in yield, quality and duration, fund expenses could be a determining factor. And, unlike forecasts of future default rates, fund fees are certain.
Here the iShares funds have the advantage. Their expense ratio is 10 basis points, compared with 24 basis points for the Guggenheim funds.
Subtracting both expenses and the annual “default factor” from the YTM figures for each target date fund produces our ALTAR Score™ rating (Figure 2). Here we arrive at the opposite conclusion as we would have drawn from the comparison based solely on YTM as in Figure 1 above.
| Figure 2: ALTAR Score™ Comparison Guggenheim vs. iShares Target Date Funds |
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| Note: As of 8/21/17. Source: www.etfresearchcenter.com |
As it turns out, the average difference in ALTAR Scores™ between the two is 14 basis points—exactly the difference in expense ratios between the two competing product line-ups. That’s not a lot, but over time it compounds of course, and in our low-yield world every basis point counts.
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