The WSJ reports that newly designed ETFs are supposed to fix some of the shortcomings of traditional bond funds. Here are some highlights from “New ETFs Look to Fix Drawbacks of Bond Funds:”
A new batch of exchange-traded funds aim to address a traditional shortcoming of bond funds: the lack of a fixed maturity. But part of the price is increased complexity.
Early this year, BlackRock Inc.’s iShares unit unveiled six municipal-bond ETFs. One advantage of these funds is that ETF shares can be bought or sold easily and at relatively low cost. With individual bonds, there’s often no way for investors to tell if they’re getting a fair price and how much profit their brokerage firm is pocketing.
The new ETFs also provide the same instant diversity as mutual funds, plus the lower fees and transparency of an ETF format. The twist is that the funds have specific maturity dates.
Investors in traditional bond funds earn interest income, but without the assurance of getting their initial investment back as they would with individual bonds held to maturity. Investors in those funds risk losing money when they cash out, should bond prices fall.
The new iShares funds don’t promise investors their investment back plus interest, but if held to maturity, the ETFs should approximate that result. The iShares 2017 S&P; AMT-Free Municipal Series ETF, for example, holds bonds maturing between June 1 and Aug. 31, 2017. The fund will wind down after the bonds mature and then return investors’ money.
But things get complicated between the time an investor buys the iShares funds and the time they mature.
With most bonds, holders know the exact interest rate they will receive. With these funds, an investor buys the fund at a certain yield to maturity. However, the interest payments during the life of the fund can fluctuate, depending on the combination of money flowing into and out of the fund and changes in interest rates.
For example, if the fund takes in money while interest rates are rising, existing holders will see their payout rise as new, higher-yielding bonds are added to the portfolio. If investors are selling, the effect on payouts depends on how the fund managers handle the process.
Presumably the primary holders of these funds will be buy-and-hold investors, so the impact of flows might not be as great as with ETFs dominated by traders. And any disparity between the expected yield at the time of purchase and fluctuations during the life of the fund will ultimately get evened out at maturity. For instance, if you buy the fund at a certain yield and receive higher distributions during the fund’s lifetime, you will receive less money when the fund liquidates.
There are other quirks as well, and almost inevitably new funds develop unforeseen issues. But in an industry too willing to cater to fast money or rely on gimmicks, these funds bear watching as a potentially attractive option. This appears to be a very intriguing concept, which attempts to bridge the gap between buying bonds outright and bond funds with their lack of a fixed maturity. If the above issues/quirks can be addressed, and these ETFs can be purchased/sold at lower costs than outright bonds, along with moderate ongoing expense ratios, this could be a worthwhile consideration for those investors looking to generate a reliable income stream.
[Emphasis added]