Benefits and Risks of Target Maturity Bond Funds

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Aaron Young

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Welcome to Advisor To Go brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Aaron Young, Vice-president, Global Fixed Income at CIBC Asset Management 

Target maturity bond funds can fit a specific role within a total investor’s portfolio. We view it as a really great way to get exposure to attractive yield, diversified investments, but for a specific short-term need of a client.  

So, the difference between target maturity and normal bond funds is these have, as I said in the name, a target maturity whereby you can expect your return of capital plus interest income and capital gains at the end of the fund. But instead of owning, say, a singular bond or a GIC or some other income instrument, this is an opportunity to meet that cash flow need across a diversified set of bonds within a single easy one-ticket solution.  

So, I would say for long-term growth, capital accumulation wealth accumulation, your traditional bond funds, corporate bond funds, still play a key role. And these target maturity funds really fulfil the short to mid-term cash flow needs of your clients, where you can point to a certainty of maturity, a certainty of return of principal, plus an attractive yield at the end of the day.  

So, target maturity funds fit nicely within an overall 60/40 balanced allocation. Again, we would argue you’re not taking away from the 60/40 positioning. That’s the tried-and-true way to accumulate wealth over the long term over the years. But we think these target maturity funds complement that model in terms of meeting short-term cash flow needs of clients. So, whether it be, you know, a large purchase you’re making in one year, paying for a child’s tuition in three years’ time, where you need that certainty of principal repayment, plus earning an attractive yield — we think these really make sense. And in fact, you can expand from that when you have multiple maturities to choose from, you actually have an opportunity to build what in the institutional business we call liability-driven investing or cash flow driven investing, whereby you can look at the near-term liabilities of your client and match those off with different target maturity funds. That sits nicely alongside your 60/40 portfolio, which is hopefully generating attractive total returns over time, and really compounding that total return to work towards a retirement goal, building generational wealth, etc. So, we think that covers off the long-term wealth accumulation in 60/40. And then shorter-term cash flow needs, whatever they may be, target maturity funds fit that bill.  

So, target maturity funds specifically have a value proposition for advisors and investors more than I would argue other similar instruments out on the market. So, from a perspective of cash-like savings instruments, so GICs, HISAs, those types of investment opportunities, I would argue target maturity funds offer additional yield. You are taking a bit more risk in terms of investment-grade corporate bonds, so it’s important to know that your manager is managing that risk appropriately. But attractive yield above what’s available in that market, option of terms going out from, you know, from one-year term out to five plus years, and diversification of exposures, in terms of not owning just exposure to one issuer or bond but multiple issuers, multiple sectors, etc.  

The other element for certain target maturity funds that prioritize the purchase of bonds trading at a discount is unlike a GIC or HISA or other cash-like instruments. If you prioritize discount bonds, you’re actually converting a portion of income into capital gains treatment. So, all else equal, holding a target maturity fund that prioritizes discount bonds should lead to a better after-tax yield. So, we think that’s important for clients who care — first of all, who are investing in non-registered accounts — and who care about how much money they take home, not just how much money they make.  

The other advantage of target maturity bond funds versus the options available to retail investors who can go out and buy individual bonds is in a maturity bond fund, you get to leverage an asset manager’s scale, expertise in the space. And fixed income continues to be an over-the-counter market whereby being larger in size, having that experience, having those relationships really gives you an advantage when it comes to sourcing bonds, finding the best bonds to put to work in a target maturity fund. We would argue that’s something that’s harder to do when you’re a retail investor, advisor going out and buying individual bonds. An asset manager can bring the weight and expertise of their history to source the best pricing for clients and investors in a target maturity bond fund. 

Target maturity bond funds definitely have a different set of risks, especially when you compare to a lot of investors who may be looking at these solutions compared to a GIC or other cash-like instrument. First and foremost, they have mark-to-market risk, so these funds are typically investing in bonds that are traded daily. The prices of those bonds also change daily based on market conditions. And therefore, like any other mutual fund, the net asset value of the fund will fluctuate day to day based on the pricing of the underlying bonds. That’s not unusual for traditional bond investors. But it could be unusual for traditional GIC investors who are moving and taking a bit more market risk.  

So, we definitely say that’s one element to be conscious of when looking at target maturity bond funds over GICs, etc.  

Now, the one thing I will say and why it works for bond instruments is, assuming no defaults, these bonds underlying these funds should mature at par value, at full value, where you get your full principal back plus the interest in capital gains you’ve accumulated over that time. So, as long as the intention is to hold to maturity, you really shouldn’t be as concerned about mark-to-market noise that happens in between then. But we also recognize that’s easy for us to say to a GIC investor who’s maybe not used to that kind of noise. So, it’s definitely an educational point to make sure that your clients and investors are aware of those moves and that the end goal is to hold to maturity.  

The other element is credit risk. Again, this is mostly investment-grade, high-quality credit risk, but there is credit risk there; you are buying bonds from corporate issuers who are not guaranteed in any way. I would say the way of mitigating risk there is really a focus on a manager who has credit research expertise, sector analysts who specialize in looking at the issuers in each of their sectors that are going to populate the portfolio. And that gives you the safety of mind to know that those risks are being looked at independently, being constantly reassessed so that when your portfolio manager goes to buy bonds for your target maturity fund, they have that sense of safety, they know that that company has been analyzed from the ground up independently, and that they’re comfortable holding that bond to the maturity date.  

What I would say to advisors is the potential for discussions on these funds to unlock other conversations. And this is really where I get excited is not only to be able to provide a solution to advisors and their clients that fits a specific need, where they have a cash flow need and want to buy a fund that matches that need. I would also say it’s interesting opportunities to generate conversations with your clients. If you’re looking at GICs that may be sitting at different institutions spread out across the banks or credit unions, these are opportunities to uncover that. Speak to them about what’s the goal of those funds. One of the biggest things that we’ve seen with advisors we’ve talked to is it’s actually opened up conversations about why are you invested in a GIC. Is it truly because you need that surety of principle and you’re meeting a future cash flow? Or is it reaction to market volatility, whereby they’ve been kind of derailed from investing over the long term and made what is in our opinion the wrong call of going to the safety of cash-like instruments, which is short termism in nature.  

So, the other thing I would say is they’re great tools to open up conversations around what your clients are doing, what’s driving those decisions, and then matching either target maturity solutions or other kind of long-term traditional investments.