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Portfolio Strategy

Target maturity ETFs: Taking aim at bigger bond returns Add to ...

One of the more sensible and rewarding answers to low yields on government bonds is also a big source of frustration for investors.

Corporate bonds offer yields that are roughly double what you can get from federal or provincial government bonds, with not much extra risk. But there aren’t a lot of corporate bonds to choose from at the typical investment dealer, and what there is available has been heavily marked up in price.

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Exchange-traded funds and mutual funds that hold corporate bonds are one alternative to buying bonds individually, but not a perfect one because these products never mature like a real bond and hand you your money back. A notable exception: The target date corporate bond ETF, which has a firm maturity date like an actual bond. Want corporate bonds for your portfolio? Then you should really check out these ETFs.

Target maturity bond ETFs were introduced in the U.S. market in early 2010. BMO ETFs was first in the Canadian market with this product in early 2011, and RBC Global Asset Management followed up just over a year ago with a big selection of its own. But while money has surged into bond ETF products in the past while, target maturity corporate bond ETFs remain bit players.

That’s too bad because these bond ETFs are a useful portfolio-building tool thanks to the fact that they mature on a preset date, just like those hard-to-buy individual corporate bonds. You can use them in a bond ladder, or you can match maturity dates with your particular financial needs.

“They’re terrific for those with a particular investing goal, like college or buying a cottage,” said Mark Yamada, president and

CEO at PUR Investing Inc. “You know what’s going to happen at maturity.”

Government bonds are what you own to protect your portfolio in case the stock market crashes, but there’s room as well for some corporate bonds in most portfolios. To be clear, we’re talking here about investment-grade corporate bonds. These bonds are less volatile than high-yield bonds, which offer much higher yields to compensate investors for the higher risk of default.

There are two reasons related to the global financial crisis that explain why investors are having trouble getting their hands on corporate bonds. One is that many companies avoided issuing bonds back in 2008, when markets were in panic mode and investors were unwilling to buy bonds without the enticement of much higher than normal interest rates. A research paper by RBC Global Asset Management says the net result is a shortage of bonds maturing in 2018-20.

The crisis also led to a toughening of regulations for global financial institutions. The combined impact has been to influence investment dealers to carry far smaller bond inventories for clients than they did pre-crisis. “As bond dealers have reduced their inventory, concentrating it amongst fewer and more recent issues, the result has been that investors’ choice in terms of diversity of corporate bond issuers and maturity dates has become increasingly reduced,” the RBC paper says.

RBC offers nine target maturity bond ETFs, each of which holds a portfolio of 30 to 40 individual corporate bonds. Maturities are available for every year from 2013 through 2021. The actual maturity date is around the end of November of each year – an exact date will be announced six months in advance.

Mark Neill, head of RBC ETFs, said that cash is paid into investor accounts when his firm’s target maturity ETFs mature. “These ETFs actually act like a bond. Investors get their money back at maturity.” As with a real bond, the exact amount you get back at maturity depends on how much you pay and on interest rate trends at the time of purchase. Corporate bonds, and target maturity corporate bond ETFs, typically trade at a premium to their par value these days. So money invested today would mature at a lesser amount than you invested upfront.

The way to understand the yield on these products is to look at the weighted average yield to maturity, which both RBC and BMO display in their ETF profiles. Subtract the management expense ratio – it runs from 0.3 to 0.35 per cent for these funds – and you have a net, real-world yield number that applies if you hold until maturity. The RBC Target 2017 Corporate Bond Index ETF (RQE) has a yield to maturity of 2.52 per cent, roughly double the yield on a five-year Government of Canada bond. Subtract the MER of 0.34 per cent and you’re left with a yield of 2.18 per cent if you hold until maturity.

In today’s low-rate world, fees are a serious drag on returns for bond fund investors. But PUR Investing’s Mr. Yamada said there’s a benefit to these ETFs that offsets at least some of the fee. Institutional investors such as RBC and BMO pay lower prices for bonds than individual investors, and that helps pump up the yields in products like target maturity bond ETFs (bond yields and prices move inversely).

One tricky element of target maturity bond ETFs is what happens to them in their final year. As the various bonds in the portfolio start maturing over that period of time, the proceeds are reinvested in short-term money market instruments to keep them safe. In recognition that cash investments don’t earn much in returns, both RBC and BMO cut their fees in the final year of a target maturity ETF.

PUR Investing’s Mr. Yamada said target maturity bond ETFs are a natural for building ladders, where you divide your investment in a bond or term deposit into segments that mature every year over any number of years (five is common). The iShares ETF family offers both corporate and government bond ETFs that automatically perform the laddering function over five- and 10-year periods, but they’re suited to investors who want a long-term, hands-off product. Target maturity ETFs make you do the work of building the ladder, but they offer extra flexibility in building and maintaining your ladder. Mr. Yamada said his firm hasn’t yet used target maturity ETFs in client portfolios, but he wouldn’t hesitate to do so. Meantime, he sees other advisers increasingly adopting these ETFs to provide exposure to corporate bonds for clients. “Many advisers are starting to cotton on to the idea that this is a better way of doing it.”

Follow on Twitter: @rcarrick

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