One of the criticisms of bond funds is that they have no maturity date. If you buy an individual 10-year bond, you know you’ll collect fixed interest payments twice a year, and you know you’ll receive the face value of the bond when it matures in a decade. But if you invest in a bond fund, you can’t be sure what its value will be in 10 years. That uncertainty can make financial planning more difficult.
Earlier this month, BMO launched a family of four new target maturity bond ETFs designed to solve this problem. They are modeled on the same principle as other target-date investment products, such as BMO’s LifeStage Plus funds (for retirement savings) and RBC’s Target Education Funds (for RESPs). Target-date funds are designed for investors with a very specific time horizon. The funds’ asset allocation starts out aggressively to maximize growth, and then get increasingly conservative as preserving capital becomes more important.
Moving from bonds to cash
While traditional target-date funds use a mix of equities and fixed-income, the new BMO ETFs use only investment-grade corporate bonds, gradually shortening the maturities as the target date approaches.
For example, the BMO 2013 Corporate Bond Target Maturity ETF (ZXA) is made up of bonds with an average term of about three years, since it is designed to mature at the end of 2013. By next year, that average term will be reduced to two years, and by December 31, 2013, the fund will be all in cash. At that point, according to the prospectus, the ETF will either continue as a money market fund, be absorbed into another BMO fixed-income fund, or be liquidated. (Investors will be notified well in advance of any change.)
The three other ETFs in the family work the same way. There are versions with target dates of 2015, 2020 and 2025, and the bonds inside these ETFs have average terms to maturity of about five, 10 and 15 years, respectively. Every year, the funds will shorten their average terms by a year, and starting about 18 months before the target date, they will begin moving into short-term instruments like you’d find in a money market fund.
The tactic BMO uses to implement this strategy is quite clever. They don’t actually select any individual bonds—rather, the building blocks are three existing ETFs. BMO already has exchange-traded funds covering short-term (ZCS), intermediate (ZCM), and long-term (ZLC) corporate bonds, and these ETFs have average terms of about three, seven and 22 years, respectively. The new target maturity funds simply hold these ETFs in different proportions. The 2020 version, for example, currently allocates approximately 82% to ZCM and 18% to ZLC. Do the math and you’ll see that this combination works out to an average term of approximately ten years.
The nuts and bolts
The most appealing feature of these ETFs is their low cost. All four have management fees of 0.30%, which is identical to the fees charged by the underlying bond ETFs. What’s more, this fee will decline as the funds get close to their target date, because the cash holdings will be subject to a fee of only 0.19%. The usual criticism of target date funds is that they charge you a fee for something simple that you can do yourself. But in this case, the convenience of the annual asset balancing comes at no extra cost.
Like all new products, these target maturity ETFs will likely be thinly traded for some time, but that shouldn’t be a major concern, since the underlying ETFs have healthy volumes. BMO seems to do a very good job of keeping bid-ask spreads tight, but as always, consider using a limit order.
The one thing that has me scratching my head is that the ETFs pay monthly distributions. I tend to think of target-date funds as vehicles for savings, not for generating income, so wouldn’t it have made more sense to structure the ETF in way that reinvests all the interest rather than paying it out in cash? BMO does offer a dividend reinvestment program, but it does not issue fractional shares, so these ETFs will have an annoying tendency to distribute small amounts of cash that may just sit around in your account earning nothing.
Are they right for you?
Who are these ETFs suitable for? You might consider them if you’re concerned about the possibility of rising interest rates as you approach retirement. By gradually shortening the duration of your fixed-income holdings, you’ll be making your bond holdings less vulnerable to losing value in the event of a spike in interest rates near the end of your working life.
Someone saving for a down payment on a home over three to five years might find a product like this more attractive than a simple savings account, although they would need to be careful to keep trading costs to an absolute minimum.
The ETFs might even be suitable for an RESP: if your child is nine years old today, for example, the 2020 version of the fund would mature just as she’s ready to begin university. If it seems too conservative, you could always combine a target maturity bond ETF with an equity index fund to get an asset mix you’re comfortable with. The usual caveat applies here, too: using ETFs in an RESP is usually only cost-effective if you make contributions once or twice a year and use a broker with low commissions.
I was tempted to write off these ETFs as the same old products with a new marketing spin. But I’ll give BMO credit where it’s due: these target maturity ETFs add a layer of management that some investors will find useful, and they haven’t charged any additional fees. It’s hard to criticize that.
Indeed, I’d encourage BMO and other ETF providers to consider introducing target-date ETFs that include both equities and fixed-income, as iShares has done in the US. They’re not a perfect solution, but they do offer a low-cost and easily managed option for investors who aren’t comfortable adjusting their own asset allocation.