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portfolio strategy

The latest hiccup in the bond market is a reminder of the flaw in today’s most popular category of exchange-traded funds.

Bond ETFs are a great way to build a diversified portfolio of government and/or corporate bonds in a single, cost-effective package. And they’re hot right now. A summary of April ETF sales from National Bank Financial reads: “$2 billion flowed into Canadian ETFs in April, almost entirely led by Fixed Income ETFs.”

The problem with bond ETFs is that, unlike the typical bond, they never mature and then return your upfront investment. The lack of a maturity date makes it harder to endure declines in bond and bond fund prices, as we saw in 2022 and again in mid-May.

Investors can work around this bond ETF flaw in a variety of ways, including high-interest savings accounts, money market ETFs and guaranteed investment certificates. Another alternative is target maturity bond ETFs, which have been tweaked for the better recently by the company that offers them, RBC Global Asset Management (GAM).

2023 Globe and Mail ETF Buyer’s Guide Part One: Canadian equity ETFs

RBC’s target maturity funds have been around since 2011, but the total amount invested in these products is just about $1.2-billion or so, whereas the most popular conventional bond ETFs have assets of $4-billion to $6-billion each.

Think of target maturity funds as a hybrid of conventional bond ETFs and an actual bond. You get the same portfolio holdings but with a maturity date. On that date, the fund is wound up like a maturing bond.

“Our tagline is that these products mature like a bond, trade like a stock and diversify like a fund,” said Stephen Hoffman, vice-president of ETFs at RBC GAM.

RBC started with a selection of corporate bond offerings and expanded earlier this month into government funds. There are corporate bond funds maturing this year and in 2024 through 2029, and a new suite of government bond funds maturing in 2024-29.

Let’s use the RBC Target 2028 Corporate Bond Index ETF (RQQ-T) as an example of how this product line works. Essentially, RQQ is like a five-year bond that matures on or around Sept. 30, 2028. The value of RQQ at maturity was recently pegged at $22.39 a unit, which compares with a price earlier this week of $20.72. This suggests a capital gain if you buy now and hold to maturity.

For now, RQQ is pretty much your basic corporate bond ETF. It holds 20 corporate bonds issued by several big banks, some insurance companies, pipelines and a few others. A couple of provincial bonds are in the mix as well.

The after-fee yield to maturity, the best indicator of future yield, was about 4.3 per cent. The management expense ratio is listed at 0.28 per cent, which is somewhat pricey for a bond ETF. However, RBC announced in April that the fees for its target maturity corporate bond ETFs will come down by about 0.05 of a percentage point.

When researching target maturity ETFs, two key pieces of information are the termination, or maturity, date and the par value, or projected amount investors will receive per unit upon maturity. You can find this data in the online fund profiles offered by RBC – look under “portfolio analysis” for par value and download an “ETF Facts” document for the termination date.

GICs have been a hot-selling bond alternative lately because of their competitive interest rates, but they score badly for liquidity unless you accept a lower rate in return for the cashable feature. Like all bond ETFs, target maturity funds can be sold any time the stock markets are open.

Mr. Hoffman pointed out an additional advantage over GICs for target maturity funds that are bought at a price below the par value and held in a non-registered account. In situations like that, part of the return will come as a capital gain. Only half of a capital gain is taxable in a non-registered account, whereas 100 per cent of bond interest is.

“You can find [target maturity] bond ETFs with a similar term as you can get for a GIC but with a superior after-tax return because of the capital gain,” he said.

One more benefit of target maturity ETFs is the fact there’s no minimum investment. You typically have to invest at least $5,000 in an individual bond bought through an online broker, and GIC purchases can have minimums of $3,500 to $5,000 or more.