August 24, 2020: Target Maturity Bond ETFs For Short Term Cash

Aug 25, 2020 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

 

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Tuesday September 1, 2020.

Please note: As of March 1, 2020, we officially phased out our old rebalance calendar for both SAA and TAA. They are now always rebalanced on the first trading day of a month. 

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Target Maturity Bond ETFs For Short Term Cash

We have discussed a special type of bond ETFs before: they were called target or defined maturity ETFs (March 7, 2016: Defined Maturity Bond Fund Analysis,  October 14, 2013: Manage Cash Investments Smartly). These bond ETFs buy and hold bonds that are going to mature in about same times, thus the named ‘target maturity’ or ‘defined maturity’. 

Since our previous newsletter in 2016, more such ETFs have been introduced into markets. What’s more, their fees have dropped to a very reasonable level. We now believe these ETFs can be really used as some type of short term cash investments. 

Fixed income investments based on cash flow expectation

Though one can use a single risk profile concept to allocate capital into stocks (funds), bonds (funds) and cash,  a more elaborate approach based on when some portion of capital is needed can be more helpful and intuitive. In general, we advocate the following: 

  • For capital needed 10 to 15 years or later, invest them in a stock portfolio using stock funds. Specifically, if you choose to invest in a strategic buy and hold portfolio such as our  Strategic Asset Allocation (SAA), it’s preferred that you’ll hold this capital for at least 15 to 20 years or longer. You can reduce the minimum number of years of investing of the capital to 10 to 15 years or longer if you choose a tactical strategy such as our Asset Allocation Composite (AAC) . Notice that we don’t give out a hard precise minimum number of years to invest for a stock portfolio here as this greatly depends on personal risk tolerance. In general, the longer, the better. 
  • For capital needed before 10 or 15 years, we suggest to invest them in fixed income (bonds) and short term cash. Here we make further refinement:
    1. For cash needed within 3 to 6months, invest in a money market fund or a CD
    2. For cash needed within 6-12 months to 2-3 years, invest in a target maturity bond fund (ETF) or their ladder
    3. For cash needed after 2-3 years and before 10 to 15 years, invest in a total return bond fund portfolio (see Fixed Income page)

Of course, if you are aggressive, you can combine 2 to 3 together and just keep withdrawing from a total return bond portfolio whenever you need money.  But allocating some money to target maturity bond ETFs or CDs gives more peace of mind, especially for money that’s essentially or critically needed. 

You’ll need to revisit/rebalance the above once a year or so. 

Target maturity bond ETFs vs. CDs

For those who are not familiar with this topic, we refer you to a recent article from the Wall Street Journal. Bonds held in a target maturity ETF mature (i.e. borrowers, mostly companies or government will return principal to the lender, you) roughly at the same time. For example, BSCM (Invesco BulletShrs 2021 Corp Bond ETF, before it was called Guggenheim) holds corporate bonds that are going to mature before December 2021, most of them should be around December. 

This type of bond ETFs were introduced in 2010 and when we covered them before, they were more expensive (expense ratios were like 0.5% or so) and they had short history. Now both have changed: first, the expense ratios have dropped to some very reasonable levels: for Invesco BulletShares Corp Bond ETFs, their fees are now 0.1% (used to be 0.45% or so), same as iShares iBonds target maturity corp bond ETFs (the other major provider of target maturity ETFs). 

Furthermore, we have some history to evaluate these ETFs now. 

An important question is that how these ETFs are compared with CDs. Let’s take a look: 

  • Similarity: Both CDs and target maturity bond ETFs will mature in a fixed target date. 
  • At the maturity, a CD is guaranteed to return its original principal. 
  • On the other hand, a target maturity bond ETF will not guarantee to return the original principal to its holders. It’s possible that because some underlying bonds default, the principal returned to the original holders will be less. 
  • Interests: a CD is guaranteed to deliver a fixed interest in a fixed period or as a lump sum at the end. 
  • On the other hand, a target maturity bond ETF can deliver somewhat different interests in a fixed interval such as quarterly. Factors cause this fluctuation include: missed interest payments from some underlying bonds; some underlying bonds mature earlier or are called; manager’s adjustment of the fund. The last one will be reflected in its price and later payments and thus it’s not a real fluctuation. 

In essence, the major difference between a CD and a target maturity ETF is that a CD has a stable and guaranteed return while a target maturity ETF has a higher return (not guaranteed but most likely) with the expense of some uncertainty of interest payments and principals. 

Remember, a CD essentially also invests in bonds and loans while it uses some portion of interests to pay for insurance to guarantee principal and interest payments. In addition, banks that issue CDs and other participants in CDs also need to derive some profit from the underlying bonds’ interest payments. 

On average, a target maturity mostly investment grade corporate bond ETF will have higher returns (cumulative interests and returned principal) than a CD as it has no insurance and other additional expenses. We look at some of Invesco/Guggenheim BulletShares target maturity ETFs that have matured since and compare that with national CD rates of the same maturity. Unfortunately, since Invesco doesn’t provide historical returned data once an ETF is mature, we have to rely on the data we collected over the years from our database. 

The following chart shows historical CD rates, courtesy of Bankrate.com: 

The following return table shows some of matured ETFs from BulletShares: 

 
  2015 Return 2016 Return 2012-2016 5 Yr AR
BSCH (Guggenheim BulletShrs 2016 Corp Bd) 0.7% 1.4% 2.98%
Bankrate national CD rate 0.28% 0.27%  1-yr CD 1.15% 5-yr CD

 

 

2016 Return

 2017 Return 2013-2017 5 Yr AR
BSCI (Guggenheim BulletShrs 2017 Corp Bd) 2.2% 1.1% 1.6%
Bankrate national CD rate 0.27% 0.33% 1-Yr CD 0.88% 5-Yr CD

 

  2017 Return 2018 Return 2014-2018 5 Yr AR
BSCJ (Guggenheim BulletShrs 2018 Corp Bd) 1.6% 1% 2.4%
Bankrate national CD rate 0.33% 0.44%  1-yr CD 0.79% 5-yr CD

The above table show both 1 year and 5 year target maturity ETF returns. For example, for BSCJ that matured in December 2018, we would assume an investor bought it in December 2017 and that would give one year mature ETF return. Similarly, if one began to hold it in December 2013 till it matured in December 2018, that would give a 5-year mature ETF return. These returns are then compared with those of CDs of the same maturity found from the Bankrate chart in the above. 

It’s very clear that target maturity ETFs provide much higher returns compared with those of CDs with the same maturity. Of course, one can say that the above examples have all occurred in a period when the Federal Reserve continued to drive down interest rates and furthermore, it has also propped up the bond market if necessary, just as what happened in March during this pandemic. 

It’s safe to say that as long as the central banks continue to support bond markets, these target maturity bond ETFs can definitely deliver higher returns with reasonable risk than CDs. 

List of target maturity bond ETFs

Currently, there are two major classes of target maturity bond ETFs: Invesco BulletShares and iShares iBond series. 

iShares iBond ETFs page shows an investor how to build a ladder using its ETFs. Currently, iShares has the following ETFs: 

As stated above, we would only suggest investors use these for capital that’s needed within 2-3 years. For anything longer than this, investors can afford to invest in a total return bond fund portfolio that in general should give higher returns. 

As for building a ladder, it probably makes little difference to build a ladder for anything needed in less than 2 years. For example, if investors have $10,000 cash that’s needed in the end of 2022, he/she can invest in the following: 

$5,000 in IBDM and $5,000 in IBDN. 

Investors can probably allocate some to high yield bond ETFs to achieve higher returns. Just to remember that high yield bonds will suffer much higher loss during a crisis. This deserves another separate discussion. 

Market overview

Amid headline stock indexes such as S&P 500 and Nasdaq making record highs daily, market internals have improved in a very slow pace. The following chart shows the total return of S&P 500 equal weight ETF (RSP):

RSP hasn’t even surpassed its high in June, let alone its February high before the pandemic. At the moment, markets are extended but on the other hand, internals have improved here and there unevenly, indicating some hesitation of commitment from investors.  

Regardlessly, we shall stick to our strategies and do the following  

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation now reached another high. For the moment, we believe it’s prudent to be cautious while riding on market uptrend. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.  

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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