These investment vehicles have specific uses – such as building a bond ladder and diversification –but be aware of their limitations
Target-Maturity Bond Funds and ETFs allow a person to access a portfolio of bonds with a targeted maturity date with a low-cost structure (in the case of ETFs) and, oftentimes, with low minimum investments.
They also offer cash flow predictability and the potential final distribution of cash at the target year maturity of the fund. When the target year comes due, the fund is supposed to receive all the cash from the redeemed bonds and distribute all the cash and then shut down.
Target-Maturity Bond Funds have opportunities:
Target-Maturity Bond Funds might be useful alternatives if you are looking to build a bond ladder that matures over different years, but you don’t have a lot of funds to do so. This way, you can get a diversified portfolio of bonds that mature in different years of your choosing. It gives you diversification, which lowers the credit risk you take so that one company defaulting wouldn’t hurt you as much because the fund has many diversified bonds.
Target-Maturity Bond Funds could also be used if you have a specific funding need, such as paying for college for your children.
However, Target-Maturity Bond Funds have potential pitfalls:
Most importantly you should know that understanding the yield, or annual interest you will earn on a Target-Maturity Bond Fund can be tricky. This is because you might look at the “weighted-average coupon” which is supposed to tell you how much annual interest you will earn each year. So, if the “weighted-average coupon” on a target bond fund is 3%, you might be tempted to believe that you will earn 3% per year throughout the term. However, that might not be accurate!
This is due to the way that these funds are allowed to do their accounting because income distributions are dependent on where the bonds are trading at. Thus, if a bond is trading at a premium, the “yield to maturity” would provide a more accurate depiction of the amount of income that would be distributed.
By using Target-Maturity Bond Fund ETFs, the investor is still subject to all the interest rates moves as well as cash flow availability and liquidity due to the decisions and actions of other investors within the same ETFs, but they may not always receive the benefit of getting principal back at maturity if there are problems during that time.
Target-Maturity Bond Funds also aren’t able to take advantage of sector allocation. You can’t choose which sector to use and which you’d prefer to avoid. There might be some sectors that are favorable and less risky to invest in such as health care; and there are some sectors that might be unfavorable and riskier, such as the energy sector or New Jersey Municipal Bonds.
Target-Maturity Bond Funds mean that the investor might be giving up active management on the yield curve. This means that if interest rates are changing, such as the significant drop in interest rates we saw in the last quarter of 2018, an actively-managed bond mutual fund might have been able to take advantage of that change, while a passively-managed ETF typically would have less flexibility to do so.
If interest rates go up during the time you own a Target-Maturity Bond Fund, the market value of that fund could go down. And if you have a longer-term bond fund, the change in value will be more dramatic than in a shorter-term bond fund. So, if you think interest rates are rising, you might want to choose shorter-term funds to be able to reinvest the funds at potentially higher interest rates.
Another pitfall is that some of these Target-Maturity Bond Fund ETFs are not very liquid because, generally speaking, they don’t trade a lot … so if you want to buy or sell them on the open market before they come due, you might end up paying a higher transaction cost to sell them in that illiquid market.
Learn more by attending an upcoming complimentary dinner workshop at Ruth’s Chris or Abe & Louie’s Steakhouse in Boca Raton or Fort Lauderdale. This workshop is best suited for those over age 60 with between $500,000 to $10,000,000 or more in investable assets. Call our office to register at 1-800-807-5558 now.
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