Ask the Spud: RBC’s Target Maturity ETFs

RBC became Canada’s sixth ETF provider when it launched a family of eight corporate bond funds last week. Unlike traditional fixed-income ETFs, which continually buy new bonds to replace those that mature, these new products have a “target maturity.” That means all the bonds in the fund will come due in the same year, and once they’re redeemed, the fund will be liquidated and all the money returned to investors.

ETFs like these are not exactly new in Canada: BMO launched four similar funds in January, with target dates of 2013, 2015, 2020 and 2025. However, RBC’s offerings fill in the gaps, covering every year from 2013 through 2020. Each ETF will mature on or about November 30 of the target year.

Extreme couponing

Whenever you buy an individual bond or a bond ETF, you’ll be quoted both its coupon and its yield to maturity (YTM). It’s crucial that you understand the difference between these two figures, or you’ll fall victim to the yield illusion that plagues so many investors.

The coupon tells you how much you’ll receive in interest payments each year, but that’s not the whole story. The YTM is a much more important number. When the coupon is higher than the YTM, it means the bonds were purchased at a premium, and they will suffer small capital losses when they mature. These losses will cause the fund’s price to fall, offsetting some of the interest payments and lowering your total return.

That’s where the YTM comes in: it factors in both the coupon payments and the expected capital loss and tells you what your total return will be if you hold the bond (or the ETF) until its maturity date. Have a look at the dramatic differences between the coupon and the yield to maturity in the new RBC funds:

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The RBC Target 2018 fund’s distributions will be a whopping 6.39% a year, but these will be offset by capital losses, so your total annual return will be less than half that: just 3.21%. Don’t be misled by those tempting coupons. You’re not going to earn 5% or 6% annually with any of these ETFs.

Target maturity v. traditional

How do these yields stack up against those of traditional bond funds? Actually, there’s no meaningful difference in risk or return if you make a fair comparison. To do that, you need to look at corporate bond funds with a similar duration, which is a measure of sensitivity to interest rate risk. (The longer the duration, the more the fund’s price will drop if interest rates rise.) I’ve included the duration of the RBC funds in the table above.

Now let’s compare these with other corporate bond ETFs. You can visit the website for Claymore’s 1–5 Year Laddered Corporate Bond ETF (CBO) and learn that it has a duration of 3.07, which makes it comparable to the RBC Target 2014 ETF. You’ll also see that he yield to maturity of CBO is almost identical at 2.29%. Meanwhile, the iShares DEX All Corporate Bond Index Fund (XCB) has a duration of 5.78, which is very close to that of the RBC Target 2018 ETF. Again, the yield to maturity of XCB is virtually the same as the comparable RBC fund: in this case, 3.25% versus 3.21%.

The only difference here is that CBO and XCB will always have approximately the same duration. The durations of the RBC funds, however, will get shorter every year as the fund approaches the target maturity date.

How to put these ETFs to work

So how might a target maturity bond ETF fit into your portfolio? You might use them to fund a future obligation on a specific date: if you know that you will need your money in 2015 for a down payment, you could buy the RBC Target 2015 ETF instead of putting it in a savings account or buying a four-year bond or GIC rates. You’ll receive interest payments for the next four years, and then have your money returned to you at the end of that period.

Target maturity ETFs do have some advantages over individual bonds. The first is diversification: each RBC fund holds 20 to 50 issues. Another advantage is that you can invest small amounts, which is difficult to do with individual corporate bonds. You can also add new money to your investment whenever you want—although you’ll incur a trading commission each time.

The RBC funds carry a management fee of 0.30%, which you would not pay if you bought individual bonds. However, the retail spread on individual bonds can be very high (and hidden), especially if you’re buying from a discount brokerage. In many cases, the ETF will be a better deal in the end.

RBC’s new ETF website suggests that you can also use these products to build a bond ladder. Presumably they will launch a new ETF every year beginning in 2013, to replace the one that gets liquidated, allowing investors to maintain an eight-year bond ladder indefinitely.

However, for long-term investors who do not have a specific time horizon, a traditional bond ETF is almost surely a better choice. First, the fixed income side of a portfolio should include government bonds as well as corporates. And second, if you do hold corporate bonds, a single fund such as CBO or XCB will be more manageable and less expensive in the long run than building a ladder with these ETFs.

Got a question about index investing? Send it to [email protected] and it may be answered in a future installment of “Ask the Spud.” Answers are provided as information only and do not constitute investment advice.