BMO’s Target Maturity Corporate Bond Funds

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.

21 Responses to BMO’s Target Maturity Corporate Bond Funds

  1. James February 14, 2011 at 12:03 pm #

    BMO is making a lot of niche products these days. I guess they’ll just collapse the products if there are no takers. Are the MER’s on top of the MER’s of the underlying funds?

    At prevailing rates, long term bonds pay 3.5% after ETF expenses, short term bonds pay less than 2%. I plan to buy a Ferrari with the difference.

  2. Canadian Couch Potato February 14, 2011 at 12:13 pm #

    @James: There’s not much space in the Canadian ETF market for anything other than niche products these days! Just to clarify, the MER on these funds is not charged on top of the underlying ETF fees. Double-charging like this a no-no in the industry.

  3. Hugh February 14, 2011 at 1:19 pm #

    It’s not clear to me what your view is of the criticism that bond funds don’t have maturity dates.

  4. gibor February 14, 2011 at 1:24 pm #

    @Canadian Couch Potato, If I understand correctly the difference between those new ETFs and for example CBO or XSB, that BMO’s Target Maturity Corporate Bond Funds changing their bond allocation every year? Later target date -> ETF will be more violatile , but on other hand will pay higher yield (up to 6%)?
    I understand that anyway you can buy and sell those ETFs any time?

    In your opinion where better to keep fixed-income, Target Maturity Corporate Bonds, regular Short term bonds ETF (like XSB) or just Saving acount 2% annual interest?

  5. Canadian Couch Potato February 14, 2011 at 1:32 pm #

    @Hugh: The observation that bond funds don’t have a maturity date is true. The question comes down to whether that bothers you or not. As a long-term investor, I don’t need to know what my bond holdings will be worth in 25 years. But if you have a shorter time horizon, a need for annual cash flow, or a fixed savings goal (“I need to save $50,000 in ten years”), then it may make more sense to use individual bonds to reach that goal.

    @Gibor: Your assumptions are correct: funds like CBO and XCS do not change their allocation from year to year, so their average terms will remain more or less the same. And yes, the farther away the target date, the longer the bonds, and therefore the higher the volatility and the higher the yield.

  6. Peter February 14, 2011 at 4:40 pm #

    I retired last year and have set up a portfolio of ETFs with 50% in bonds. I now have serious doubts that lower volatility is worth the huge tax hit. My pension (defined benefit) is in the OAS clawback zone, so at 65 my marginal tax rate will jump to 51% (36 federal, 10 Alberta, 15 clawback). The rates for eligible dividends (about 30%) and capital gains (25.5%) are a bit better, though none of these numbers puts a smile on my face. I have considered income sharing but, since I am single, I would first need to find a partner in a lower tax bracket. That strategy would introduce substantial risks associated with marriage market timing and house renovations, the latter triggered by disparate utility functions. Points to ponder before the next pon farr. Happy Valentines Day!

  7. gibor February 14, 2011 at 6:05 pm #

    It would be great if Canadian Couch Potato can write article about all this pension stuff…. for me it’s extremely confusing.
    I have currently RRSP, SRRSP, LIRA and DCPP (that later I will convert to LIRA).
    Those my assumptions:
    My understanding that all income I get on the accounts above are tax – sheltered whatever i get interest, dividends , capital gain etc.

    When I become older , I suppose to convert RRSP and SRRSP into RRIF, and LIRA into LIF , and again all my income is tax – sheltered. From LIF and RIF accounts I will be getting some minimum AWD payment monthly or annually and this money is not taxable. Also, I suppose to get some money from CPP and OAS (I’m not sure if they’re taxable or not and what are brackets).

    TFSA is a separate story, I don’t pay any taxes on any income regardless of my RIF, LIF, OAS, CPP payments.

    Could you please let me know what in my assumptions are correct and what are incorrect?

  8. Canadian Couch Potato February 14, 2011 at 6:49 pm #

    @Gibor: Your questions are well beyond the scope of my blog (and my expertise). I’d recommend that you speak with a tax specialist or financial planner.

  9. open source portfolio February 14, 2011 at 10:55 pm #

    I think all of this would have been a lot more appealing if bonds had a decent yield to them. At 2% is it even worth it?

  10. BC_Doc February 15, 2011 at 12:55 am #

    Thanks for the interesting article. I’ve been looking at the “Legal and Regulatory Documents” section of the BMO website to gain a clearer understanding of the these ETFs. After reading the prospectus, it’s not entirely clear to me exactly how much these ETFs’ shares will be worth upon “maturity” nor exactly when the ETFs “mature.” Additionally, I am unable to find a report or section of a report which clearly discloses performance and tracking error of the underlying funds. Am I missing a report or section of the website which discloses this information?

  11. Canadian Couch Potato February 15, 2011 at 1:23 am #

    @BC_Doc: There’s no way to know what these ETFs will be worth at maturity, because movements in interest rates will affect the funds’ value. (So these ETFs don’t entirely solve the problem with bond funds that I alluded to at the beginning of the post. But they just make the ride less volatile and more predictable.) However, the maturity date is clearly spelled in the prospectus out as December 31 of the the target year.

    To learn the performance and tracking error of any fund, go to http://www.sedar.com/search/search_form_mf_en.htm, type the name of the ETF into the search box, and choose “Management Report of Fund Performance” from the pull-down menu. This semi-annual document tells you the fund’s performance relative to the benchmark index. Keep in mind that the BMO corporate bond ETFs have only been around since late 2009 and early 2010, do their track record is still very short.

  12. The Dividend Ninja February 15, 2011 at 12:10 pm #

    Hi Dan. If an investor wants the higher income from Corporate Bond Funds, then Claymore CBO ETF (as you have recommended before) is a much better option. It has a very reasonable yield at 4.6%, and since the holdings are laddered in 1-5 year maturities – you are already hedging against interest rate hikes. If anything I see to much guesswork with these BMO products, not certaintiy.

  13. gibor February 15, 2011 at 12:48 pm #

    @open source portfolio, 25 year bond hs yield amost 6%
    @ The Dividend Ninja, I bought CBO mostly because it had highest yield comparing to XSB and CLB

  14. BC_Doc February 15, 2011 at 12:50 pm #

    Thanks for the follow-up CCP.

    The information from the prospectus is too murky for my taste– move to cash is +/- six months from maturity date, value of units is not known at maturity. The benefit of the bond ladder or GIC ladder is that one knows that s/he is getting their principal back on the maturity date. With these funds, the investor still doesn’t know how much they are going to get back.

    With the Vanguard and iShares ETFs, it’s quite easy to determine how the funds have performed, and how this compares to the corresponding index. One doesn’t have to hunt to find this basic information. Based on what I’m seeing in the BMO disclosure documents, I believe I’d pass on these funds at the present.

  15. Canadian Couch Potato February 15, 2011 at 1:05 pm #

    @Ninja: For short-term investments you’re right, but the longer target maturity ETFs (going out 10 years or more) should have a higher yield because the bonds are much longer than those in CBO.

    @BC_Doc: Agreed that a GIC or bond ladder is much more predictable. You could build your ladder out five or 10 years, and then as each bond matures, simply put the proceeds in a savings account rather than rolling it into a new bond. Like so many financial products, this one can easily be replicated at lower cost by a knowledgeable DIY investor.

  16. Paul February 15, 2011 at 3:35 pm #

    @Ninja: You have to be careful though, CBO and CLF have high returns interest-wise but there is loss of capital along the way, so the actual yield going forward is in the 2% range. I think CCP had a post about this some weeks/months ago.

  17. Canadian Couch Potato February 15, 2011 at 3:40 pm #

    @Paul: Thanks for stressing that important point. Here’s the post with the details:
    http://canadiancouchpotato.com/2010/11/22/bonds-gics-and-the-yield-illusion/

  18. gibor February 16, 2011 at 1:18 pm #

    @ Paul , looks like lost of capital is not only for CBO and CLF, but for all short term bond ETF…

    @All There is very nice website http://www.etfchannel.com/ where you can see all ETFs that hold any stock with % holdings and vise versa. But it’s only for US ETFs. Is anyone knows similar website for Canadian ETFs?
    Frequently I want to know which Canadian ETFs holds for example ABT, JNJ or INTC, but cannot figure it out…..

  19. Chris February 17, 2011 at 5:24 am #

    @Gibor, can you explain why you want to do that kind of thing? (i.e. look up which Canadian ETFs hold a given US stock?) I can’t figure out the motivation. It’s almost certainly better to choose ETFs based on a top-down approach. If you’re concerned about overlap in holdings with individual stocks that you also own, once you have an ETF in mind, you can check its top 10 holdings to see if there is substantial overlap. In most cases, any overlap should be minimal, except perhaps with the very largest stocks by market capitalization.

    Instead of this kind of micro-managing, you should take a look at Canadian Couch Potato’s model portfolios. For a beginning or intermediate investor, they are all solid and well-thought out (though they are all overweight Canada; if you wanted to, you could tone down the Canada allocation from 20% to 10% to reflect Canada being only roughly 6% of the market).

  20. gibor February 18, 2011 at 12:48 am #

    @Chris , I ant to look up not only which Canadian ETFs hold a given US stock, but also which Canadian ETFs hold a given Canadian stock. I tried to explain it in the post above…. lets say I like some US Health or Canadian Rare metals stock, but I don’t want to be exposed to just 1 stock, I want sector ETF (as I just don’t have enough time to track one stock every day) and I want it in $CAD (FX rate is a killer at my bank) .
    Just to clarify, I allocate just small part of my portfolio to such ETFs/Stocks.

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    […] Couch Potato presents BMO’s Target Maturity Corporate Bond Funds, saying, “One of the criticisms of bond funds is that they have no maturity date. If you buy […]

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