Investment Product Review

 

In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

Defined Maturity Funds: Is it a bond, a fund, or both?

In a previous post we discussed the most common types of investment funds; mutual funds and exchange traded funds (ETFs).  This review will focus on a specific version of these funds, the defined maturity fund.  A defined maturity fund (DMF) is, simply put, a fund which has a specified ending date, which is generally included in the name of the fund.  For example, a 2020 fund would be a fund that would close down and return all assets to investors at some point in the year 2020.  This implies that, one way or another, all assets in the fund must be liquidated at or before the maturity date of the fund.  Other than the predefined closing date, these funds operate just like funds without defined maturities.

This fund structure is becoming increasingly popular in asset classes comprised of securities with specific maturities, the most common being fixed income.  The intuition behind this is straightforward; a defined maturity fund will have characteristics that are similar to a defined maturity security.  As an example, a defined maturity bond portfolio ending in 2015 will have many of the same features as an individual bond with the same maturity date.  This is quite significant, as it allows investors to buy a diversified bond fund that behaves like an individual bond.

To appreciate the full importance of this structure, it is important to first look at the current state of the economy.  Interest rates are at historic lows, and are essentially at a lower bound, meaning that they can only go up in the future.  This is significant for bondholders, because the price of a bond has an inverse relationship with interest rates, meaning as rates go up, bond prices will decrease.  For investors with exposure to fixed income through bond funds with no ending date, this may mean a temporary negative return.  An individual bondholder can avoid this loss in value by simply holding that bond to maturity, in which case they will receive the full par value of the bond.  However, holding individual bonds is not necessarily a cost effective way to invest for most people, and it loses any diversification benefits provided by bond funds.

This is where defined maturity bond funds can fill a role in an investor’s portfolio.  A DMF will build a portfolio of bonds with the majority set to mature at or around the ending maturity date.  At the ending date, net assets are distributed to investors, much like a bond maturing and returning principal to the holder.  Also, like any other bond fund, they provide diversification and liquidity benefits not available to someone holding an individual bond.  In this sense, defined maturity bond funds provide the best aspects of both individual bonds and bond funds.  While the value of a DMF will decrease in a rising rate environment, an investor who holds the fund to its stated maturity will likely not suffer this loss of value because they will receive the fund assets at maturity, which will mainly consist of maturating individual bonds.

Another useful aspect of these funds is that, much like individual bonds, they can be built into a “laddered” portfolio.  This process involves creating a portfolio with securities that mature at regular intervals, to provide consistent cash flows as well as to avoid locking up an overly large portion of assets for an extended period of time.  For example, an investor could purchase bonds or bond funds maturing in 2013, 2014, 2015, and so on, and in this way create a laddered portfolio that is both liquid and subject to less interest rate risk than a standard fixed income mutual fund.

Given the current interest rate environment, we suggest that investors, particularly those without a very long time horizon, consider the laddering approach to fixed income using these defined maturity funds.  As of this writing, these funds are available for investment grade and high yield corporate bonds, as well as municipal bonds.  This type of portfolio is somewhat more costly to set up than an investment in a single bond fund, but it will likely reward investors in an increasing interest rate climate.

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About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

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