Investors overwhelmed by the vast array of bonds available today have a simple solution: buy a fund. Managed bond funds leave the hard work to professional managers, and index bond funds, like their stock-owning counterparts,…
Investors overwhelmed by the vast array of bonds available today have a simple solution: buy a fund. Managed bond funds leave the hard work to professional managers, and index bond funds, like their stock-owning counterparts, simply buy the bonds in an underlying index.
But standard bond funds don’t allow the investor to simply wait out down periods as one can do with stock funds and individual bonds that can be held to maturity. If bond prices are down when you need your money, you could wipe out years of interest earnings.
A few fund companies have tackled this problem with target maturity exchange-traded funds designed to return the investor’s principal on a given date, like an individual bond does, while also getting the diversification offered by a fund with many holdings.
Typically, these funds purchase individual bonds that will mature around the target date. Invesco, for instance, offers a series of Bulletshares government and emerging market bond ETFs maturing every year from 2018 to 2028.
“Target-mutual funds can serve as havens for anyone with a due date,” says Mark J. Grant, chief global strategist with B Riley FBR and B Riley Wealth in Fort Lauderdale, Florida. “This would be especially true for people going to college or buying a house, or retirees that are looking at lifestyle changes.”
Michael K. Creamer, principal at Glass Jacobson, a wealth advisory firm in Rockville, Maryland, notes that bond investors currently face the risk of losing money as interest rates rise, a risk target-maturity funds can address.
“Target-maturity bond funds are an excellent way to manage interest rate risk,” he says. “They also provide instant diversification, professional expertise and risk management.”
Another benefit is steady, predictable yield, says Niko Finnigan, an advisor with Delta Wealth Advisors in Hinsdale, Illinois. These funds typically hold bonds to maturity, while ordinary bond funds’ yields can fluctuate as older bonds are replaced with newer ones.
“This means bondholders can calculate how much they expect to earn until the bond fund matures at a given date,” Finnigan says.
But no investment is perfect — investors can and do lose money in target-maturity funds, just as they do with individual bonds.
Prices of bonds and bond funds fluctuate as market conditions change. When interest rates rise, for instance, older bonds lose value because investors prefer newer ones that pay more.
Prices fall farther for bonds with more time to mature, since it’s worse to be stuck with a stingy bond for 10 years than for two. But as the maturity date approaches the bond price gets closer and closer to the face value, because investors know they’ll get that much when the maturity date arrives.
That’s why investors in individual bonds can just wait to maturity if a factor like a spike in interest rates drives down their bond price in the meantime. Of course, that can also mean living with a below-market yield until that date arrives.
Ordinary bond funds don’t have a maturity date, because they constantly buy and sell bonds to maintain an average maturity promised to investors — two years, five years, 10, or whatever. So, there’s no waiting for a maturity date to get face value. Instead, the fund will always provide the risks and potential rewards of a bond with a given maturity. With a long maturity it will likely pay more and be riskier than with a short maturity.
Target-maturity funds, like individual bonds, assure a given sum will be available on the maturity date even if rates or other factors have changed dramatically. But the fund’s value can still dip in the meantime.
“These funds have the same risks as investing in bonds generally,” says Geoffrey Smith, finance professor at W. P. Carey School of Business at Arizona State University. “That is, default risk, liquidity risk, reinvestment rate risk, maturity risk, tax risk.”
These funds are best, then, for investors who expect to need their cash on or about the maturity date, Smith says.
“They are better than individual bonds due to the diversification of default risk and the liquidity of the ETF structure,”Smith says. “Plus, professional managers make the investment decisions, so there might be some cost savings there, too.”
If the plan is to reinvest the principal, there’s always the risk it won’t be a good time due to low yields in new funds, heightened risks or some other issue. Experts say investors can manage that risk by purchasing a variety of funds with different maturities.
So, many urge investors to think carefully about what they’ll do with the fund proceeds after the principal is returned, and to consider alternatives if the child may not go to college after all, or if retirement or that vacation home purchase may not happen on schedule.
The target-maturity fund “is a preferred alternative to the average investor trying to (diversify) by purchasing a basket of individual bonds,” Creamer says. “As long as the credit quality and duration of the target-date bond portfolios are consistent with the investor’s time horizon, goals and risk profile, they are a useful tool for managing short and intermediate term financial obligations.”