A New Approach to Bond Funds

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While a broad array of bond ETF choices exists, until recently, investors have had few choices for targeting specific maturities. Typically, these choices only include ranges, like the iShares Barclays 7-10 Year Treasury Bond Fund (NYSE: IEF  ) . However, over the last year, Guggenheim Funds and BlackRock's (NYSE: BLK  ) iShares have made an important innovation in bond ETFs: specific maturity-date funds.

An investor can typically reduce price risk by buying a single bond and holding it to maturity. As long as an issuing company doesn't end up in default, its bonds will be priced at par at maturity, thus allowing an investor to wait out any price shocks in the meantime. But because each bond typically costs $1,000, it can be challenging for small investors to buy enough individual issues to be properly diversified; instead, they turn to bond funds. Until now, that has meant losing the ability to hold till maturity.

Enter Guggenheim's BulletShares maturity-date corporate and high-yield bond ETFs, and iShares' maturity-date municipal bond ETFs. The table below lists the available maturities. Tickers for each advance alphabetically each year.

Time Frame

BulletShares Corporate Bond ETF

BulletShares High-Yield Bond ETF

iShares S&P National AMT-Free Municipal Bond ETF

First maturity Guggenheim BulletShares 2011 Corporate Bond ETF (BSCB) Guggenheim BulletShares 2012 High Yield Corporate Bond ETF (NYSE: BSJC  ) iShares 2012 S&P AMT-Free Municipal Series ETF (NYSE: MUAA  )
Last maturity Guggenheim BulletShares 2017 Corporate Bond ETF (NYSE: BSCH  ) Guggenheim BulletShares 2015 High Yield Corporate Bond ETF (BSJF) iShares 2017 S&P AMT-Free Municipal Series ETF (NYSE: MUAF  )

How they work
Each fund only holds bonds that mature in a given year. The individual holdings in the fund will start maturing at the beginning of each year, and as they do, the funds invested will transition into cash and cash equivalents such as T-Bills and commercial paper. The funds will distribute interest on the bonds each month, and the fund ultimately terminates on or around a specified date -- Dec. 31 for the Guggenheim funds, and Aug. 31 for the iShares ETFs -- on which it will make a cash distribution of its remaining assets to its shareholders.

How to use them
Concentrating entirely on a single maturity can create certain problems for an investor. Short-term bonds typically have lower rates, but long-term bonds lock your money up for longer periods of time. That may force you to sell at an unfavorable price if you need to free up capital at some point.

It's possible to alleviate these problems by establishing a bond ladder with specific maturity-date funds. Instead of buying, say, $10,000 worth of one maturity, you might put $2,000 into each maturity from 2012 to 2016. Then, as each fund terminates, you could either use the cash for current needs or reinvest it in a new long-term maturity. For instance, in 2012, you could take your distribution and buy shares of a 2017 fund. By staggering the investments, you can withdraw money from the soonest-maturing fund if necessary, without having to sell at a terrible price.

Because there are only so many issues at any given maturity, diversification won't be as broad in these funds as it is in a typical bond fund. The BulletShares 2012 corporate bond fund has only 78 securities, for example, compared to the popular iShares Investment Grade Corporate Bond Fund (NYSE: LQD  ) , which has more than 600. While the BulletShares corporate bond series must invest in investment-grade bonds, an unexpected catastrophe in one of the holdings could have a big impact on returns.

The funds also have very low volume, which can make entering and exiting a position difficult. However, since the point is to hold till maturity and possibly never sell, collecting the final distribution instead, this shouldn't be much of a problem.

Final thoughts
These funds are an important innovation and should go a long way toward helping investors add a bond allocation to their portfolios. There are certain risks, but building a ladder with these funds provides an opportunity to reduce much of the risk inherent in traditional bond funds.

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Fool contributor Jacob Roche holds no position in any of the stocks mentioned. BlackRock is a Motley Fool Inside Value selection. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 21, 2011, at 12:19 PM, kblommewe wrote:


    Interest rate risk trumps any of the touted benefits of attempting to pick and choose winners and losers in bondland.

    Buying individual bonds remains a fools gambit mainly due to opportunity costs.

    If interest rates go up after you bought you MISSED out: opportunity cost.

    We need to be more thoughtful in our approach and really feel every possible scenario through. Not just read the latest article or book and end up doing long term damage to our capital. If we do not; we will pay with a requisite amount of labor.

    K. L. T. Blom

  • Report this Comment On March 21, 2011, at 12:46 PM, TMFTheDoctor wrote:

    That's why I mention bond ladders. Ladders mitigate interest rate risk by diversifying across the yield curve. A typical bond fund will get slammed when rates increase because its holdings will fall in value, but a maturity-date fund could be held to maturity, thus removing the price risk, leaving only the problem of a lower-than-market rate, but again, a ladder would reduce that problem. Thanks for reading.

    - Jacob

  • Report this Comment On June 09, 2011, at 4:27 PM, annedonc wrote:

    If one purchases the BSCH fund (maturity date 2017) now, one is buying above par per the starting date of 6/2010,the current market price is about 6% higher. If held to maturity in 2017, one loses 6% of your investment principal, something to consider

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