2023-11-10 07:00:00 ET
Summary
- iBonds and BulletShares products offer a more liquid alternative to owning individual bonds.
- They come with risks, including higher credit risk and lower yield compared to individual bonds.
- iBonds provide diversification and liquidity, but have limitations such as cash flow issues and reliance on larger issuers.
- Remember, a stock fund is a good replacement for individual stocks, but a bond fund is not a good replacement for individual bonds.
- In short, you give up nearly 1% in total yield per year over the term of the fund to take MORE credit risk. That is partially offset by the advantage of monthly distributions and daily liquidity.
*Side Note: I used the term iBonds throughout the report but in fact, it would apply to Invesco's BulletShares product as well. They are interchangeable with only minor differences.
This article is not only directed primarily towards those who do not like buying individual bonds, but also those who want a more liquid alternative to owning individual bonds.
While I think these can be used to replace individual bond purchases, they are not a perfect fit by any means. In fact, I think they are more risky for less yield given the constraints funds have including buying more indebted companies and cash drag in the final year.
In short, you give up nearly 1% in total yield per year over the term of the fund to take MORE credit risk. That is partially offset by the advantage of monthly distributions and daily liquidity.
We highlighted an article recently on how a stock fund can be a good replacement for owning individual stocks, but a bond fund is NOT a good replacement for owning individual bonds.
That main difference is having that pull-to-par.
That is the natural tendency for a bond to drift towards par as it approaches maturity.
A bond fund has hundreds or thousands of individual bonds in it. They are constantly maturing and being replaced. That means as interest rate changes the new bonds will be bought at the then current rates.
If rates move lower, and new money flows into the fund, new bonds will be purchased diluting the older, higher yield with newer, lower yields. Over time, the bond funds yields will move lower correlating with interest rate trends.
That negates one of the key characteristics of an individual bond - that pull to par and the locked in yield to maturity the bondholder receives.
BlackRock and Invesco have attempted to change that with their BulletShares and iBonds suites of products. They are designed to mature like a bond, trade like a stock, and diversify like a fund. Sounds great, right?
The BlackRock funds have been around since 2010, and we have numerous historical data points to use to study their effectiveness as a bond substitute. Since then, two treasury, two high yield, 11 municipal, and 13 investment grade corporate bond ETFs have successfully liquidated.
The key variable that one doesn't know is the monthly income distributions and final NAV payment which will vary based on the yield of the bonds entering the portfolio. Those are based on when investors put money in the fund.
This is the daily cash flow problem which these funds DO NOT solve for. Investors tend to put money in at the wrong time and sell at the wrong time. I know. I was shocked at this fact too!
An iBonds is an ETF wrapper with bonds of all the same maturity year in the portfolio. The ETF then is designed to self-liquidate at the end of that given year and return your 'original investment'.
The above table shows the differences between iBonds/BulletShares and individual bonds, bond ETFs, bond mutual funds, and closed-end funds. The main difference between iBonds and individual bonds is diversification and liquidity.
With an iBonds ETF, you get instantaneous diversification across dozens of bonds. For those that build individual bond portfolios, you will have to buy a dozen or so bonds (we recommend at 1% TLA or less which may require more bond positions to accomplish).
In terms of cash flows, the ETFs pay monthly while bonds typically pay semi-annually. However, owning a larger portfolio of individual bonds typically smoothes out those semiannual cash flows to a more stable income stream (though it won't be steady it will be more consistent).
In the year of the maturity of the iBonds, the fund will start to have underlying bonds mature. In the first six months, the fund will reinvest the proceeds into another bond that is maturing later in that year. In the last six months to maturity, it will remain in cash or cash equivalents.
How Have They Performed?
We can look at the performance of the funds that have come and gone over the years and compare that to a portfolio of individual bonds.
The corporate bond ETFs are the best examples of how these work and contain the least amount of slippage , and deviations in performance from a real portfolio of individual bonds.
The table below shows the variation of the initial yield to maturity of the portfolio and the final NAV Total Return that the fund gained over its life. You can see that the large slippage was in the 2021 fund, primarily due to COVID, amounting to 0.4%. However, in most years, it is less than 15 bps.
Muni iBonds are even more efficient at reducing slippage.
One of the largest drawbacks of the ETF approach (iBonds or BulletShares) is the requirement for the issue to be larger. That allows the fund to buy a significant position for their fund and allows them to further add to the position as cash flows enter the fund.
An individual DYI bond portfolio doesn't have that restriction. A smaller issuer is not necessarily more risky but most of the time, results in a higher yield as compared to a similar bond that has a larger amount of bond issuance.
Additionally, these portfolios are not actively managed but follow a sub-index primarily selected by notional issuer size. So you're going to have a lot of highly indebted issuers being the largest weights in the portfolio.
When I'm selecting individual bonds, one of the key considerations is the total debt load of the issuer. I don't want to buy an AT&T or other large capital company with a lot of debt. These funds do that.
Another key consideration is the liquidation date versus the bond maturities. The bonds do not all liquidate on the same date in the final year, often liquidating months earlier. As we noted above, if the bond matures in the last six months of the year, it is kept in cash. That cash can be a big drag on the portfolio if it isn't invested in something.
In terms of taxation, accretion towards par is counted as income in that given year.
Portfolio Applications
For those looking at gaining exposure to individual bonds without actually purchasing individual bonds (something we highly recommend), these are an okay substitute though not perfect. Given the constraints, you are likely giving up about 75 bps to nearly 1 point.
For example, the iShares iBonds Dec 2033 Term Corporate ETF ( IBDY ) [this was incepted in June of this year] has an initial yield of 5.91% with a weighted average coupon of 5.19%. This tells me that they are buying newer issues (clearly few of the 293 holdings were issued prior to 2022 given the higher coupon).
I also do not like the holdings that much of either the iBonds or BulletShares as they are skewed towards the more indebted companies, likely
But you do gain liquidity - individual bonds are more difficult to sell though not nearly difficult at all compared to exchange-traded security.
I wouldn't mind using these in accounts that are smaller where individual positions are not economical. Most brokerages require a $10K minimum for each bond.
Side Note Hack:
I like using these portfolios when hunting for individual bonds for my research/purchase. ETFs are required to post their holdings daily and by weight, so we can see what each maturity ETF owns.
Concluding Thoughts
I like these ETFs as a replacement for individual bonds given that they do have that terminal value, which is a key advantage of owning an individual bond over a bond fund.
Remember, a stock fund is a good replacement for individual stocks, but a bond fund is not a good replacement for individual bonds. The reason is because of that terminal/maturity date benefit and the pull to par.
These are better than nothing but are far from a perfect replacement for individual bonds.
For further details see:
iBonds/BulletShares Are 'Okay' (At Best) Replacements For Individual Bonds