An ETF That's an Ideal Bond Substitute

Buy a high-quality bond and you’re sure to get your money back when the debt comes due. But most bond funds offer no such assurance because they don’t have a fixed end date. Now some exchange-traded funds are trying to be more like individual bonds by building in a cash-out date for investors to recoup their money. One such ETF is Kiplinger ETF 20 member iShares iBonds Mar 2020 Corporate ETF (symbol IBDC).

At last report, the fund held 306 investment-grade bonds issued by highly rated companies, such as Apple, Bank of America and Verizon Communications, that all come due between April 1, 2019, and March 31, 2020. As the end date approaches, the fund will pile up the cash from its maturing bonds and it will cease to exist—delisting from the stock exchange around that date and shelling out the proceeds to investors (after fees and expenses).

That termination feature can be attractive for people who want a lump sum at a future date—say, to buy a car or pay for college. Moreover, as the ETF approaches its expiration date, it should hold its value, reducing the risk of a steep drop just before you cash out.

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“Target maturity” ETFs do have drawbacks. One is that their share prices tend to trade above the net asset value per share of their underlying bonds, typically by about 0.4%, according to Vanguard Group. The iShares 2020 ETF recently traded at a 0.3% premium to its NAV, and that premium shaves your yield while you hold the fund. It will also trim a bit off the top when the fund liquidates because it will cash out at its NAV, rather than at the premium price you will likely have paid for the fund.

And despite the termination feature, the ETF is not immune from interest-rate risk. The fund’s average duration is 3.5 years, suggesting that its price would slump by 3.5% if rates were to rise by one percentage point. If you had to unload the ETF before its maturity date, you might take a loss.

Perhaps the biggest downside is what happens in the fund’s final year or so of existence. As its bonds mature, the ETF’s cash position will expand until it eventually reaches 100%. During that span, the yield will inch down as the fund holds fewer bonds and more cash. The yield may eventually drop to almost nothing (unless short-term rates rise sharply from today’s near-0% level).

Although the ETF isn’t perfect, it can make sense if you package it with similar funds. Guggenheim Investments and iShares sell bond ETFs maturing in the mid 2020s, including high-yield funds from Guggenheim and tax-free municipal bond ETFs from iShares. Bundle a few together and you could build an ETF “ladder” with a range of yields, credit risk and maturity dates. If rates climb in the next few years, you could swap a maturing ETF for one with a higher yield, winding up with more income without additional risk.