BulletShares ETFs: A viable alternative to bonds?

Buying individual bonds

Buying individual bonds allows investors to insulate their fixed-income allocations from interest rate risk. Investors who rely on individual bond issues are able to match bond duration to the timeframe of their expected liability in an easy and straightforward manner. 

For instance, consider the young investor with 20+ years to go until retirement, which is the point that they will begin to withdraw from their portfolio. In this case, buying a longer-duration U.S. Treasury bond with 20 years until maturity may be sensible.

In this case, even if interest rates rise and the price of the long-term Treasury tanks, the investor is shielded from its effects. They still receive the coupon payments and are guaranteed their principal investment when the bond matures, right when they need it. 

That being said, transacting in individual bonds has two major drawbacks: illiquidity and opaque valuations. When it comes to liquidity, individual bonds are often much less liquid than equities. This can cause price distortions, a notable example occurring during the March 2020 COVID-19 crash.

Because bonds trade over the counter (OTC) from individual issuers, investors need to devote significant time researching, conducting credit risk analysis, and figuring out if the pricing is fair. These investors may receive different quotes from various brokers and can be subject to markups. 

Buying bond ETFs

Bond ETFs hold a portfolio of individual bonds in a basket. They can be passive via tracking an existing index, or actively managed with the goal of outperforming some benchmark. The advantages of bond ETFs include greater liquidity, transparent pricing, and monthly versus semi-annual distributions. 

However, a big disadvantage of bond ETFs is their constant maturity. Consider your typical aggregate bond ETF, which holds issues from corporate and government entities across all maturities, weighed in the portfolio to average out to an intermediate duration. 

To maintain this constant maturity, the bond ETF continually sells bonds that are expiring or falling short of the target maturity (for instance, a long-term bond ETF will sell bonds with less than a certain number of years until maturity) while buying newer issues. 

This is a problem for investors looking to immunize against interest rate risk. One only needs to consider the retirees in 2022 who were shocked by their 60/40 portfolio drawing down as much as a 100% equity one. In this case, the constant intermediate duration of their aggregate bond funds was the culprit. 

Because bond ETFs don't have a maturity date where the investor receives their principal investment back, they are constantly exposed to interest rate risk. To remedy this, investors are forced to change bond ETFs or add shorter-duration ones as their time horizons narrows, which can be a hassle. 

Invesco BulletShares ETFs

An innovative and novel instrument that has the potential to blend the best of individual bonds and bond ETFs is Invesco's suite of BulletShares ETFs. 

Each BulletShares ETF provides targeted exposure to bonds of a certain maturity. For example, buying the Invesco BulletShares 2029 High Yield Corporate Bond ETF (BSJT) provides exposure to bonds maturing in 2029. The advantages are numerous:

• Reduced interest rate risk as each BulletShares ETF "matures" by its target date. When this occurs, the ETF terminates operations and distributes its net asset value (NAV) back to investors, simulating how individual bonds return the principal at maturity. 
• Greater liquidity and transparency: Like traditional bond ETFs, BulletShares ETFs trade on exchanges under their own tickers, with narrow bid-ask spreads thanks to the ETF creation/redemption process. 
• Monthly distributions: BulletShares ETFs distribute income on a monthly basis, compared to the semi-annual coupon payments made by individual bonds. 
• Diversification: BulletShares ETFs provide broad exposure to multiple issuers, which helps mitigate credit risk. 

The possibilities here are endless. For example, an investor retiring in 2024, and seeking a low-risk bond fund can buy the Invesco BulletShares 2024 Municipal Bond ETF (BSMO). Even if interest rates rise, the investor will receive the NAV of the ETF when it matures in 2024.

Another great way of using BulletShares ETFs is to construct a bond ladder. This involves staggering multiple BulletShares ETFs with different maturity dates, so a constant stream of interest-rate immunized income is achieved. This helps investors match cashflows to expected liabilities. 

Please note this article is for information purposes only and does not constitute investment advice.