Revolutionizing the Fixed-Income Funds Industry

revolutionizing fixed incomeCurrently, stocks are a better buy than fixed-income instruments; but fixed-income instruments are still a very important part of most retirement portfolios.  There are multiple good options remaining for fixed-income investors.  Among these are (1) buying CDs with a term of about five years or less to hold to maturity, (2) buying individual corporate or municipal bonds with a term greater than about five years to hold to maturity, and (3) buying BSCK, which is an investment-grade corporate bond ETF (exchange-traded fund) that will, basically, hold its bonds to maturity and, then, provide the principal in cash to shareholders.

There should be many good fund options for fixed-income investors, but there are not.  The main reason for this is that, currently, almost all of the fixed-income funds maintain a fairly constant years-to-maturity profile.  They sell holdings prior to maturity and buy replacement holdings with more years-to-maturity; or, when holdings mature, they replace them with other holdings, versus returning the principal in cash to the fund shareholders.

The fairly-constant-years-to-maturity approach is bad for two reasons.  First, the odds are strongly in favor of interest rates rising in the coming years; and fund shareholders will very probably experience a related significant or large loss in the value of their shares.  Second, even when we are not in a very-probably-rising interest rates environment, the fairly-constant-years-to-maturity approach leads to shareholders unnecessarily taking on interest rate risk.  Generally, when bought individually versus via a fund, fixed-income investments are safer than stocks.  Currently, if you are invested in a typical longer-term fixed-income fund, the investment is, arguably at least, not safer.

There are two important questions regarding this situation.  (1) What different actions should you, as an investor, encourage from fixed-income fund providers going forward?  (2) What should fixed-income fund providers do differently going forward?  Ideally, the answers to these two questions are the same.  However, the fund providers are businesses.  Their decisions are almost entirely based on profits, not altruism.  Investors need to show a strong enough interest and, more importantly, a willingness to reflect this interest in dollars (or another currency).  If investors do not, it very likely does not make sense for the fund providers to act.

Below are the actions investors should be encouraging from fixed-income fund providers.  Fixed-income fund providers should be looking at taking these actions even less any encouragement from investors.  A few years from now, interest rates very probably will have increased a lot; and fund providers will be blamed, some, for not acting if they do not act fairly soon―whether this is fair or not.  As explained above, though, there needs to sufficient investor interest as well.


(1) We need far more funds that hold bonds to maturity and, then, provide the principal in cash to shareholders.

From this point forward, I will refer to these funds as TMTC (to-maturity-then-cash) funds.  Currently, Guggenheim offers a series of investment-grade corporate bond TMTC ETFs, one ETF for each maturity year from 2013 to 2020.  They also offer a series of junk corporate bond TMTC ETFs, one ETF for each maturity year from 2013-2018.  iShares offers a series of investment-grade municipal bond TMTC ETFs, one ETF for each maturity year from 2013-2017.  Also, iShares has submitted documentation to the SEC regarding offering a series of investment-grade corporate bond TMTC ETFs with bonds seemingly maturing in April-March 2015-2016, 2017-2018, 2019-2020, and 2022-2023.  I am not aware of any TMTC mutual funds, but I do not follow the mutual fund industry nearly as closely as I follow the ETPs (exchange-traded products) industry.

Per ETF Database, there are 49 ETP providers.  As you can see above, only two are offering TMTC ETPs―and their offerings are too limited.  We have no investment-grade municipal bond TMTC ETPs with a target date beyond 2017, no junk municipal bond TMTC ETPs, no investment-grade corporate bond TMTC ETPs with a target date beyond 2020, and no junk corporate bond TMTC ETPs with a target date beyond 2018.  Also, there are no competing TMTC ETPs currently being offered.  That is, there is only one provider for each type of TMTC ETP and target year.

Currently, I am less concerned that TMTC funds are not being offered for fixed-income instruments other than corporate bonds or municipal bonds; but I am concerned.  CDs, corporate bonds, and municipal bonds are better investments now; but, for example, I would rather see folks invested in a TIPS (Treasury Inflation-Protected Securities) TMTC fund than non-TMTC one.

The fixed-income funds industry can offer more TMTC funds in two ways.  (1) Through introducing new funds.  (2) Through converting existing funds into TMTC funds.  The mechanics of converting would be relatively easy for some funds.  Factors that make converting easier are (1) having a lot of money invested in the fund, (2) having a small, closely bunched number of maturity years that the fund covers, and (3) having a large number of holdings in the fund, if there is a significant chance that the holdings will default.  A fund would be converted by breaking the fund up into multiple funds, one for each segment of a maturity year, maturity year, set of maturity years, or a combination thereof.  The fund would then be a fund series, versus a single fund.  Some holdings may have to be sold and replaced with other holdings to facilitate the conversion.  This kind of a conversion has not, to my knowledge, occurred yet.  One may never occur, but it is possible.

Even though funds that have failed to attract a lot of money do not have a lot of money invested in them, they may, still, be good candidates for conversion.  A key question is:  “How much more expensive is it to convert the fund than it is to close the fund and start a series of funds, if it is more expensive?”  If the fund is converted, it would have an already existing base of investors, versus having to start from scratch.


(2) We need many of these new TMTC funds to hold fixed-income instruments with more years-to-maturity.

Generally, well-chosen CDs are the best fixed-income investments for terms of about 5 years or less.  This is a mathematical reality.  If a TMTC fund evolves to the point where the years-to-maturity slips to about 5 years or less, so be it.  As long-term investors, we should, generally, continue to hold the fund until maturity.  On the other hand, new TMTC funds that have a years-to-maturity of about five years or less are not a good value for the typical investor.


(3) We need a decrease in the expense ratios for TMTC funds.

The investment-grade and junk Guggenheim TMTC ETFs have expense ratios of 0.24% and 0.42% respectively. The existing iShares TMTC ETFs have expense ratios of 0.30%.  When well-structured, TMTC funds are easy to administer.  The expense ratios do not need to be nearly this high.  Some of the TMTC ETFs for which iShares has submitted documentation to the SEC have proposed expense ratios of 0.10%.  Competition should bring down TMTC fund expense ratios.


(4) We need TMTC funds to return the principal associated with matured fixed-income instruments more quickly.

The Guggenheim TMTC ETFs return principal at the end of the target year, but the ETFs hold bonds maturing across the breadth of the target year.  Basically, for example, when you buy BSCK, you are buying about 7.3 years of longer-term investment-grade corporate bonds life and about 0.5 years of short-term investment-grade corporate bonds, short-term Treasuries, and/or cash life.

The existing iShares TMTC ETFs are better in that they only hold bonds maturing from about June 1 to August 15, and they return the principal in cash to investors on about August 31.  However, there is a downside to only holding instruments maturing during a part of the year, without there being funds holding like instruments maturing during the remainder of the year. You can increase market prices for the instruments you are holding in relation to the market prices for like instruments maturing during the remainder of the year.  You can end up buying and selling at inflated prices.

A better solution is to return the principal associated with matured instruments with each monthly dividend distribution.  Basically, this is not capital gains being distributed (along with dividends).  This is return of principal being distributed.  As TMTC fund investors, we do not want to buy part longer-term instruments and part short-term instruments and/or cash.  We simply want to buy the longer-term instruments we intended to buy.  Monthly distribution of the principal associated with matured instruments better accomplishes this.


(5) To the extent warranted, we want individual TMTC funds in a series to cover half years, quarters, or individual months instead of whole years.

For example, instead of having one fund per target year in a series; there would be two, four, or twelve funds per target year.  Investors will need to be patient regarding this.  There may need to be a lot more money invested in TMTC funds to enable this on a cost-effective basis.  Also, for ETFs, there are concerns regarding the ability to buy or sell shares at a reasonable price.  When fewer shares are traded in an individual ETF, it is more difficult for investors, versus traders, to buy or sell at a reasonable price.  Funds covering individual months may never be warranted.  However, the more tightly targeted the TMTC funds become, the better it will be for investors in that investors will be able to better pinpoint their investments and return of principal.



Some of what I stated above may not be immediately doable.  For instance, there may be a regulation or law that prevents it.  If so, it does not mean that we should not pursue the course of action I presented, or one like it.  It just means that some people will need to work harder in the pursuit.  Often, we are too quick to say something cannot be done or will not be done, instead of envisioning what should be done and enabling it.  This is an instance where envisioning and enabling are very much warranted.  I invite you all to envision and enable, to the extent you can, along with me.


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Kurt Shrout


    • JMB, Fixed-income ETPs tend to trade at a premium. The best explanation I have seen for this is that the NAVs are based on the bids, versus the midpoints of the bids and asks. I think the thing to do is to attempt to avoid buying at a premium significantly greater than the spread between the bids and the bid/ask midpoints.
  1. That’s great and all but it is better to maintain a fixed duration bond portfolio (unless you are a Liability Driven Investor, then it’s ok to hold until maturity) because having a non-target duration is a form of market timing. Then you have to worry about what interest rates will be in the future. Saying that it is highly likely that interest rates will go up is following the crowd and ignoring the history of interest rates as well as current sovereign bond interest rates. Furthermore if you go on the 5 to 10 year curve you get a nice roll return, the capital gain (or cushion if interest rates rise) that you get if interest rates stay the same, which you do not get if you hold to maturity.
    • John Love Pousse, The basic facts are: (1) Interest rates are projected to increase a lot and are much more likely to rise than fall. Economists’ consensus projections, the coming end of QE, etc. tell us this. (2) Interest rates have been falling, generally, for about three decades and are now very low by historical standards, but they cannot go much below 0; hence, history also indicates that rates are more likely to go up than down moving forward. (3) In investing on the basis that interest rates are likely to increase a lot, you are not exactly following the crowd because the money has not moved much in anticipation of this yet. For one, if it had, interest rates would likely be up a lot more already. Also, we know this from fund investment/divestment flow information, etc. It is sometimes correct to agree with crowd thinking. What you need to be careful about is following crowd money flow, and being after the crowd. (4) If you are in a non-TMTC fixed-income fund and related interest rates rise, you will experience a loss of principal. This loss is avoidable if you or the fund holds fixed-income investments to maturity instead. (5) If interest rates stay even and you own a non-TMTC fund, you will achieve a non-tax-adjusted total return about equal to the YTW (yield-to-worst) less default losses, if any, and less the fund’s expense ratio. Every fixed-income fund I have looked at would experience a capital loss in a steady-interest-rates environment, as the bonds or whatever will return to nearer par value upon getting close to maturity.

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