With interest rates very likely to rise in the upcoming years, there are only three good bond or bond-like investment options for people who are investors versus traders ―well-chosen CDs, individual bonds, and to-maturity-then-cash (TMTC) bond funds. On 7/16/13, two more TMTC funds were launched. This raised the total count of TMTC funds to at least 35. In this article, I will detail what TMTC funds are now available and provide insights into matters such as costs, diversification provided, and ease of trading; and I will summarize the factors that determine whether individual bonds, TMTC funds, or a combination of the two are best for you.
Below is a chart listing the TMTC funds now available and their characteristics.
There are six series of funds available. Each series contains four to ten individual funds, each of which matures in a specific year. iShares has three series―one for investment-grade corporate bonds, one for investment-grade corporate bonds less financial company bonds, and one for investment-grade municipal bonds. Guggenheim Investments has two series―one for investment-grade corporate bonds and one for high yield corporate bonds. Fidelity has one series, which is for investment-grade municipal bonds. Guggenheim has 16 individual funds, iShares has 14, and Fidelity has 5. The Fidelity funds are mutual funds. All of the other funds are ETFs.
The assets of all of the funds combined total about $3.8 billion. The Guggenheim funds account for about $3 billion (78%) of this total. The corporate bond funds account for about $3.3 billion (86%) and the municipal bond funds account for about $0.5 billion (14%) of the total. The corporate bond funds have been much more popular with investors. This is probably because (1) the municipal bond market is only 29% of the municipal and corporate bond markets combined and (2) the higher-income retail investors for which municipal bonds are most attractive are (a) generally more sophisticated investors and, hence, more prone to buy individual bonds and (b) more able to have someone buy individual municipal bonds for them.
Although they are growing quickly, the assets of TMTC funds are still only a tiny portion of all bond fund assets. Nonetheless, each TMTC fund series is somewhat equivalent to a single non-TMTC fund. For instance, the Guggenheim investment-grade corporate bond series is tantamount to a 0-9.44 years-to-maturity fund; and the Guggenheim high yield corporate bond series is tantamount to a 0-5.44 years-to-maturity fund. Viewed as a single fund, these series now rank 34th and 36th (out of 236) respectively among bond ETFs in terms of assets.
High yield corporate bond funds account for 42% of all TMTC corporate bond fund assets. Only about 15% of outstanding corporate bond assets are high yield. In this light, we can see that the high yield corporate bond segment has been the most successful TMTC fund segment to date. This is probably because (1) sufficient diversification is much more difficult to achieve in the high yield realm and TMTC funds provide a very large degree of diversification and (2) more people have been chasing yield recently due to interest rates being so low.
In looking at the chart above, you can see that four different timings are being applied as to when, during the year, funds mature―3/31, 6/30, 8/31, and 12/31. The iShares municipal bond funds are holding bonds maturing across 2.5 months, whereas the other funds are holding bonds maturing across a full year. In contrast to the other funds, the Fidelity funds will sell some bonds prior to bond maturity; but these bonds should have about 6 months or less remaining to maturity upon their sale.
Normally, the fact that the funds slowly transition to holding short-term instruments, like short-term corporate bonds or 3-month Treasuries, or cash during their final months or year would be a disadvantage. Currently, it is probably not a disadvantage for the medium-to-long-term funds though. The Federal Reserve (Fed) is likely to begin raising the target federal funds rate in about 2015; and this rate, and therefore rates like the 3-month Treasury rate, are projected to reach about 4% in about late 2017.
Diversification, Costs, and Trading Volumes
With a weighted-by-assets average of 192 bonds per fund, when you exclude funds maturing in 2013, intra-fund diversification is more than sufficient. (Funds maturing in 2013 have sold some of their bond holdings as a part of the to-cash process.)
Costs are, generally, higher than average. This is true both in terms of expense ratios and premiums versus discounts. On the bright side, the expense ratios and premiums versus discounts are very good for the iShares corporate bond funds; however, the premiums versus discounts in the chart above are only based on a single moment’s data. The premiums versus discounts are based on the net asset values (NAVs) upon market close on 7/24/13 and the bid/ask spreads immediately prior to the 7/24/13 market close.
Trading volumes are sometimes an issue. This is particularly true for the iShares corporate bond funds. There are days when there are no or almost no trades in these funds. Good prices, or, even, discounts, appear to be obtainable in these funds; but you may need to be rather patient to obtain them.
There are cost factors and potential cost factors not reflected in the chart above. From a fund-centric perspective, these costs may or may not be limited to fund brokerage (i.e., trading) expenses. Institutions like fund managers have much lower brokerage costs on a percentage basis than retail investors do. Both the Guggenheim funds and the Fidelity funds sometimes buy and sell bond holdings to take advantage of pricing inefficiencies. This may partially offset or more than offset fund brokerage expenses. The iShares funds may have a like pricing-inefficiencies-trading policy; but, if they do, I am unaware of it.
To-Maturity Bond Funds vs. Individual Bonds
For buy-and-hold investors, for shorter duration bond or bond-like investments, well-chosen CDs tend to be the best choice―due to factors like interest rates, upfront and ongoing costs, and the potential for default losses. For medium-to-long-term investments, individual bonds are generally less costly to buy-and-hold than TMTC funds. Sometimes, they are far less costly. People who are more sophisticated investors, have more money to invest, have more spare time, and enjoy the process of investing more are, very often, better off investing in individual bonds. If you are not a more sophisticated investor, you have a limited amount of money to invest or time to commit, or your interest in investing is limited, a well-chosen TMTC fund(s) is probably a better option for you.
The choice does not need to be one or the other though. You can invest partially in individual bonds and partially in TMTC funds if this is what serves you best. Also, you can invest in TMTC funds; but, then, over time, learn more about investing in individual bonds. As you learn more, become more comfortable buying and holding individual bonds, and find individual bonds that you want to purchase, you can transition from being a TMTC fund(s) holder to an individual bonds holder.
Without realizing it, you can easily end up grossly overpaying for individual bonds. Also, if you solely invest in individual bonds versus TMTC funds, you will probably need to own at least about 10 corporate and/or municipal bonds to be satisfied with your level of diversification. Furthermore, well done, buying and holding individual bonds is like buying and holding individual stocks. A good amount of research and monitoring is warranted for each purchase. LearnBonds is very good vehicle thru which to learn about buying and holding individual bonds wisely.
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About Kurt Shrout
Kurt has a BA and MA in Communication and over 20 years of business experience, almost always serving as a project or program manager, director, consultant or as an analyst. He lived and worked in many different locations in the U.S., London, England, and Hong Kong. He has experience in at least 18 different industries and 31 different enterprises. Although he was only 49, he essentially retired in 2008 and began spending a lot more time studying investing. His articles are largely written as a public service. They provide investors with a rare totally unbiased view of the investing landscape and often include unique analysis. You can read more of his articles by clicking here.