From the vantage point of logistics, fixed-income ETFs are the greatest thing since sliced bread since they feel, trade, are taxed, and are monitored the same way stocks are. But we’ll have to give up some convenience to in order to avoid getting burned by these products, which seem to have been designed as if rates would fall and bonds would rise forever. Fortunately, two ETF sponsors have already dipped their toes into the waters of what hopefully will become Fixed Income 2.0.

A Bond ETF Is Not A Portfolio Of Bonds

Fixed income ETFs 1.0 is a case in which one plus one equals one half, or something like that. That’s because unlike bonds, fixed-income ETFs don’t mature. As Bond A approaches maturity, the portfolio manager sells it and reinvests the proceeds into another bond.

That may not sound like a bid deal. Managers trade stocks all the time. But bonds are different. They are designed to mature. And this isn’t just a legalistic formality. Bond math, and the arsenal of risk-control tactics available to fixed-income mangers (e.g., managing duration), goes out the window if we cancel the maturities.

A portfolio-average duration can be calculated for any fund at any time based on its current holdings. But the significance of this metric as a risk control device presumes that the holdings will progress one period after another to maturity. That’s why even for professional fund managers, turnover tends to be low. They don’t trade unless they need to. In an ETF, however, the portfolio manager is regularly recalibrating the portfolio to stay in compliance with a targeted duration, so that metric becomes useless as a tool for risk management and is reduced to simply being a marketing bullet point.

It’s fine to eliminate fixed-income risk-control techniques when interest rates are plummeting and bond prices are soaring, as has been the case for most of the time since 1982 and especially in the 2000s, when many of these funds were created. But when rates start rising and bond prices start falling, the absence of risk-control capabilities likens these funds to drag racers driving cars without brakes, as I demonstrated in my last post.

A Potential Solution

If a carmaker builds cars without brakes but learns that customers would like a way to decelerate without crashing into walls, the solution is pretty easy: Start building cars that come with brakes.

That’s pretty much what iShares and Guggenheim have started to do. They introduced sets of ETFs that actually include the standard fixed-income risk control. I’m referring here to target maturity funds (which come with some cool brand names, Bullet Shares in the case of Guggenheim and iBonds in the case of iShares). These funds are hold bonds that mature at a stated point in time and as the time nears, the funds get cash from bond redemptions and eventually pay proceeds to shareholders and terminate the fund. (Presumably, they’ll also keep adding new funds for future years as time marches on.)

Voilà! We’re back in the bond market. We get to work with duration and maturity. We can manage our risks. If we decide to shorten our durations, say from 20 years to the 7- to 10-year range, we can don’t have use a fund like the iShares 7-10 Year Treasury EFT ($IEF), which says 7-10 years in the name but doesn’t really mature but instead keeps turning over its portfolio such that even in Y3K, it will still be 7-10 years away from maturity. We now can choose Guggenheim BulletShares 2023 Corporate Bond ETF ($BSCN), iShares iBonds Mar 2023 Corporate Bond ETF ($IBDD), iShares iBonds Mar 2023 Corporate ex Financials Bond ETF ($IBCE), etc..

Because you know when $BSCN, $IBDD, or $IBCE mature, the portfolio duration numbers they publish really mean something regarding risk.

But alas, nothing is perfect.

Two Caveats

There are two important concerns to using BulletShares or iBonds ETFs.

First, you lose one of the benefits you expect from funds of all kinds. You can’t be passive, nor can you expect the fund manager to make active decisions for you. How short should you go? Maybe 2023 is not the best maturity. Perhaps you’d be better off with), iShares iBonds Mar 2018 Corporate Bond ETF ($IBDB) or Guggenheim BulletShares 2020 Corporate Bond ETF ($BSCK).

It’s on you to decide – or on your financial advisor. So yes, you’re stuck with being active. Then again, is there really such a thing as passive investing? Isn’t ownership of the S&P 500 SPDR ETF ($SPY) and active bet on U.S. large cap momentum (i.e. through market cap weighting in lieu of Smart Beta weights)? Isn’t any choice to allocate between stocks and bonds (and how much of each) versus being entirely in one or the other an active choice?

What about one of the larger generalist total-market-oriented fixed-income funds like Vanguard Total Bond Market ETF ($BND), Schwab U.S. Aggregate Bond ETF ($SCHZ), or even those focused on Treasuries such as iShares Core U.S. Treasury Bond ETF ($GOV). They don’t have maturity mandates like we see for $TLT or $IEF. That’s a plus in that each fund has exposure to the full spectrum of maturities and durations that are available in the market. But again, it’s not the same as it would be if you had a portfolio of actual bonds with varying maturities. Whatever average durations these portfolios have, their function remains the same as for $TLT; marketing copy. Those funds won’t actually mature, ever, but will instead be continually readjusted as mangers conform to the proprietary indexes they must track. Hence the risk-control benefits of duration (gradually progression of each bond toward maturity) cannot be realized.

So yes, you give up simplicity when you use BulletShares or iBonds. You have to pick your own maturity schedule through choosing a single fund or by “laddering” (selecting multiple ETFs that mature at different times). But once you start thinking in terms of fixed income (as you will down the road when interest rates start rising and the financial media saturates the investment community with relevant commentary), you’ll find yourself in a familiar position, analogous to choosing large cap versus small cap, value versus growth, tech versus something else, etc.

The other caveat you may already have noticed is that these are corporate bond funds, not Treasury funds. That means you are taking on credit risk. (And right at the start, you are called upon to agree or disagree with iShares’ position that there’s merit to a line ofiBond corporate ETFs that exclude companies in the Financial sector (see, e.g., $IBCE).

Excluding the high-yield bond market (such ETFs do exist, so make sure you check the fund name to assure you get what you want, whatever your stand regarding high yield), I believe credit risk, while present, is less troublesome than the interest-rate risk we face going forward. While I’m not convinced junk bond investors are getting as much of a premium (in terms of above-Treasury yields) to take on the credit and liquidity risks in that area, I believe holders of investment grade corporate bond ETFs are being reasonably compensated. Needless to say, in order to assume rates will rise in the future, as I do, I also assume decent economic growth. If we go into recession, either it will happen at a time when interest rates have room to fall (in which case we can comfortably plunge back into the Version 1.0 standards like $TLT), or it will happen when rates are too low to fall, which would entail a horrific economic scenario that likely will leave nobody any place to hide.

Summing Up

So far, investors have not rushed into BulletShares (assets in these investment grade funds range from $26.9 million to $906.9 million and average $389.4 million per fund) or iBonds (assets in these funds range from $9.5 million to $172.3 million and average $46.6 million per fund). That compares to $144.8 billion for industry-gorilla total market $BND, and $5.5 billion for maximum-interest-rate-risk $TLT.

Clearly, the ETF industry still has its work cut out for it with Fixed Income 2.0.

We need target maturity Treasuries (unless the industry is giving up the ghost here and assumes interested investors will buy these at their e-brokers or at Treasury Direct, a user-friendly site that allows investors, including individuals, to buy directly from the U.S. Department of the Treasury).

It would also be nice if the industry could put some marketing behind this, particularly publicizing the process for liquidation and cashing out (it really isn’t a big deal, but it would be nice if it could be explained to investors without the usual legalese). And what’s up with iShares? How does an industry leader like that have so little in its iBond product line? If it’s reluctance to come out against it’s big guns, such as $TLT, I hope the company can find a way to move past that before Mr. Market does it for them.