Why Target Date Bond Funds Beat Bond Index Funds

by Darwin on September 23, 2012

Picking a stock fund is fairly easy – a stock index fund built around a market index like the S&P 500 should do just fine. Bonds are a different animal, however, and index funds may not be the best choice for your investment dollars.

Bond Funds vs. Target Date Bond Funds

In general, there are two different types of bond funds:

    1. Average maturity funds – These funds select bonds based on their average maturity date. One example is iShares 1-3 Year Credit Bond ETF (CSJ), which holds bonds in maturities ranging from 1 to 3 years.
    2. Target date bond funds – Target date bond funds purchase bonds based on a maturity date. For example, the Guggenheim BulletShares 2017 Corporate Bond ETF (BSCH) holds bonds that mature in 2017.

The difference between the type of funds is the exposure that they maintain. If you were to buy an average maturity fund, the maturity would not change as you age. An investment in the iShares fund with a 1-3 year maturity would have an average maturity of 1-3 years 10 years from now, just as it does today.

However, an investment in target date bond funds keeps your maturities constant. As time passes, the 2017 Guggenheim target bond fund would drop in maturity from 5 years in 2012 to 4 years in 2013 and so on. Target-date funds are especially good for people who want to reduce interest rate risk over time. As each year passes, there is less time to maturity, and so there is less rate risk.

Consider this example: A retiree wants to buy a bond fund for income. He targets an 8 year maturity, and buys the Guggenheim BulletShares 2020 Corporate Bond ETF (BSCK). He enjoys a 3% yield for the next 8 years. When the fund matures in 2020, the face value of the underlying bonds is returned to him. Rising or falling rates have no effect on the value of the fund at maturity. The same cannot be said of rolling maturity funds.

Build Better Bond Exposure

There are a few ways to use target date bond funds to your advantage:

    1. Build your own maturity profile – Investing 50% of your investment in a 2013 fund and 50% in a 2018 fund would give you an average maturity of 3 years. There is no other way to build such a specialized maturity profile with other bond funds.
    2. Make a ladder – You can create your own bond ladder by investing evenly among different maturity dates and then reinvesting the proceeds in the longest date. The benefit here is that you have a rolling maturity exposure, but you have the power to end your reinvestments whenever you please. An average maturity fund does give you a basic ladder, but you have no power on winding it down. People who ladder CDs might prefer a corporate bond ladder for similar maturity control but with higher yields.
    3. Formulate a working tax strategy – Assuming you have taxable and non-taxable accounts, target date bond funds allow you to keep the highest yielding funds in untaxed 401ks or IRAs while storing your lowest yielding funds in taxable accounts, intelligently shielding more income from immediate taxation. High income and high net worth savers benefit the most from this particular target date fund advantage.

Some Important Considerations

    • Always go one year longer than you want. A target-date fund with bonds maturing in 2014, for example, would have maturities on every inch of the calendar from January to December 2014. Always add one more year to the maturities you really want to target. Pickier investors might buy two consecutive target date funds to round off at an averaged maturity date. This also gives the benefit of broader bond diversification.
    • Buy ETFs with limit orders. Because niche funds can be less liquid than others, you’ll want to buy with limit order to ensure that you do not pay a large premium to the fund’s net asset value. You can check a fund’s net asset value on the issuer’s website.

List of Target Date Bond Funds

If you have an interest in using target date bond funds, here’s a comprehensive list of choices from low-cost issuers like Guggenheim and iShares:

Corporate Bond ETFs
Guggenheim BulletShares 2012 Corporate Bond ETF (BSCC)
Guggenheim BulletShares 2013 Corporate Bond ETF (BSCD)
Guggenheim BulletShares 2014 Corporate Bond ETF (BSCE)
Guggenheim BulletShares 2015 Corporate Bond ETF (BSCF)
Guggenheim BulletShares 2016 Corporate Bond ETF (BSCG)
Guggenheim BulletShares 2017 Corporate Bond ETF (BSCH)
Guggenheim BulletShares 2018 Corporate Bond ETF (BSCI)
Guggenheim BulletShares 2019 Corporate Bond ETF (BSCJ)
Guggenheim BulletShares 2020 Corporate Bond ETF (BSCK)

High Yield and Junk Bond ETFs:
Guggenheim BulletShares 2013 High Yield Corporate Bond ETF (BSJD)
Guggenheim BulletShares 2014 High Yield Corporate Bond ETF (BSJE)
Guggenheim BulletShares 2015 High Yield Corporate Bond ETF (BSJF)
Guggenheim BulletShares 2016 High Yield Corporate Bond ETF (BSJG)
Guggenheim BulletShares 2017 High Yield Corporate Bond ETF (BSJH)
Guggenheim BulletShares 2018 High Yield Corporate Bond ETF (BSJI)

Municipal bond ETFs:
iShares 2013 S&P AMT-Free Municipal Series ETF (MUAB)
iShares 2014 S&P AMT-Free Municipal Series ETF (MUAC)
iShares 2015 S&P AMT-Free Municipal Series ETF (MUAD)
iShares 2016 S&P AMT-Free Municipal Series ETF (MUAE)
iShares 2017 S&P AMT-Free Municipal Series ETF (MUAF)

 

Aside from target date bond funds, there are plenty of other exciting bond hybrids and investments like the following:

 

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