Defined Maturity ETFs Instead of Bond Ladders

Written by Luke Rynehart, Global Economic Intersection Associate

Bond ladders are a popular investment strategy that allow total control over cash flows and minimize exposure to inflation and interest rate fluctuations. By selecting a diversified bond portfolio with staggered maturities an investor is able to select the exact cash flows they desire and the exact date of maturity of their investment.

An investor may wish to stagger the maturities in short intervals of only a few months to ensure a steady stream of cash flow or long intervals of a few years that will typically enjoy higher returns. This high level of control in cash flow makes Bond Ladders a popular choice for investors,  who use returns for income. The steady cash flow also has the added benefit of providing protection against inflation and interest rate fluctuations that serve as a constant risk to any investor purchasing fixed term maturities.

If interest rates are increasing at the time of a maturity date an investor can re-invest the cash at a higher return. If interest rates are falling then you still have the remaining maturities in your bond ladder earning higher returns than you would have if you had opted for short term maturities for your entire portfolio. Either way the Bond Ladder allows you to smooth out interest rate fluctuations and provides added security.

The downsides of the Bond Ladder are the transaction costs and prohibitive entry prices. Bond transactions typically face wide bid/ask spreads, the name given to the difference between the highest price offer from prospective purchasers and the lowest sale price offered from bond holders.

Setting up a Bond Ladder with short interval maturities will provide a steady cash flow and high degree of protection from interest rate fluctuations, but the reinvestment process will incur high transaction costs due to frequent trading. In addition to this, setting up a well-diversified portfolio of bonds for a ladder system can come with very high initial start-up costs. An investor looking to set up a 5 year Bond Ladder system with bi-annual maturities must purchase bonds to mature in 9 periods at sufficient levels to cover the impending transaction costs. This can be a prohibitive factor in setting up a ladder system unless one is dealing with a high value portfolio of several hundred thousand dollars or more.

In response to the problems discussed above product developers have created a new Exchange Traded Fund (ETF) that aims to provide the cash flow benefits of a ladder system whilst bypassing the start-up cost problems due to the fact that it is a single product that investors can enter into with a single transaction.

An ETF is a security that is designed to behave the same way as a specific index or a collection of securities. An example being an ETF that is set up as a portfolio of shares that has been collated to track the performance of an entire commodity sector, such as oil, and is then sold to investors as a packaged product. The new Defined Maturity ETFs are portfolios designed to provide the same general level of control over cash flow intervals as a ladder system.

But they are not able to provide the same level of control on exact cash flow amounts as they are subject to fluctuations depending on the specific components of the package. These fluctuations are due to the fact that the Defined Maturity ETF is not a bond as such, but a combination of stocks and securities that are indexed to behave in the same way as a bond but are not immune to market movements. The fact that it is sold as a packaged product negates the prohibitive start-up costs of an individually created Bond Ladder but doesn`t address the high frequency transaction cost concerns. There are also concerns over liquidity as trading has been slow over the last year or so since these Defined Maturities ETFs were introduced.

The Defined Maturity ETFs are an interesting proposition for the investor who wants the cash flow control and added security of a ladder system but can`t get past the initial start-up cost. Liquidity problems are likely to lessen as the market familiarizes itself to the new product but the inherent transaction costs still need to be calculated carefully by any prospective investor.

The specific portfolios:

Guggenheim Investments currently offers 3 Defined Maturity ETF`s all traded on NYSE

The Guggenheim BulletShares 2012 Corporate Bond ETF (NYSE:BSCC)

Monthly distribution schedule, expected termination date 12/31/12

Sector Weighting

Finance                                                            84.90%

Consumer Non-Durables                              3.5%

Utilities                                                             2.84%

Technology Services                                       2.43%

Health Technology                                          1.15%

Consumer Services                                         1.15%

Electronic Technology                                    1.12%

Communications                                              0.95%

The Guggenheim BulletShares 2013 Corporate Bond ETF (NYSE:BSCD)

Monthly distribution schedule, expected termination date 12/31/13

Sector Weighting –

Finance                                                                          57.95%

Electronic Technology                                                 6.27%

Consumer Non-Durales                                              5.29%

Retail Trade                                                                   3.78%

Communication                                                            3.61%

Consumer Services                                                       3.55%

Health Technology                                                        3.52%

Producer Manufacturing                                             2.72%

The Guggenheim BulletShares 2014 Corporate Bond ETF (NYSE:BSCE)

Monthly distribution schedule, expected termination date 12/31/14

Sector Weighting –

Finance                                                                  50.20%

Electronic Technology                                        7.13%

Consumer Non-Durable                                      5.87%

Health Technology                                              5.73%

Energy Minerals                                                  4.98%

Communications                                                   4.65%

Consumer Services                                                4.37%

Retail Trade                                                            3.21%

BlackRock currently offers short and long term fixed income ETF options traded on NYSE

iShares Core Total US Bond Market ETF (NYSE:AGG)

Sector Weighting –

Treasuries                                                           36.2%

MBS Passthrough                                            29.49%

Industrial                                                             11.98%

Financial                                                               6.21%

Agencies                                                              6.03%

Utility                                                                    2.4%

CMBS                                                                    1.92%

Supranational                                                    1.46%

Local Authorities                                              1.37%

Sovereign                                                            1.24%

Other/Undecided                                            1.89%

iShares Core Long-Term US Bond ETF (NYSE:ILTB)

(10 years+)

Sector Weighting –

Treasuries                                                           37.56%

Industrial                                                             28.18%

Utility                                                                    7.78%

Financial                                                               7.4%

Local Authorities                                              6.79%

Sovereign                                                            4.35%

Agencies                                                              3.65%

Financial                                                               1.25%

Industrials                                                           0.97%

S-T Securities                                                     0.91%

Other/Undecided                                            1.17%