Bond Funds Key for Fixed-Income Investors

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Here’s an intriguing idea for fixed-income investors: an exchange-traded fund that invests in a basket of bonds but, like an individual bond, has a fixed maturity date. It should help control the interest-rate risk that has bedeviled people who invest in bonds through funds.

The six iShares S&P AMT-Free Municipal Series bond ETFs, offered by BlackRock Inc. deal with a problem that’s particularly worrisome today — the prospect that rising interest rates could torpedo the value of your bond holdings.

Sooner or later, most fixed-income investors learn about the problem of interest-rate risk. If you pay $1,000 for a bond yielding 4%, no one will give you $1,000 for it if newer bonds are paying 5% or 6%. A one percentage point rise in rates can cause some long-term bonds to lose 10% of their value, wiping out years of interest earnings.

Interest-rate risk is a special concern right now, because most experts think rates will gradually rise.

There is a solution: you can hold your bond to maturity. That way, you are assured of getting the bond’s full face value no matter what has happened to its price in the meantime. But buying individual bonds can be challenging, to say the least. They’re not traded on a central exchange like stocks, so it’s very hard to know if your broker is giving you the best price.

That’s why most small investors buy bonds through mutual funds. Funds give you wide diversification and professional management, and it’s easy to move money in and out.

Unfortunately, you cannot hold a mutual fund share until it matures, because there is no maturity date. A fund may hold dozens of bonds, perhaps hundreds, and the portfolio must constantly change so the manager can maintain an average time to maturity promised to investors. Funds with longer average maturities tend to have higher yields but more risk; short-maturity funds are safer but less generous.

The six new iShares ETFs aim to solve this problem by having fixed maturity dates from 2012 through 2017. The fund maturing in 2017 (Stock Quote: MAUF), for example, owns a basket of municipal bonds maturing that year. If you hold the shares until then, you should get a return of principal reflecting the face value of the bonds in the fund, though BlackRock does not guarantee a specific amount. The fund currently yields about 2.6%. Since that’s from tax-free municipal bonds, it’s the equivalent of 4% for an investor in the 35% tax bracket and 3.47% for one in the 25% bracket.

The ETFs have a relatively low expense ratio of 0.3%.

Because these funds have been available only since January, it’s too soon to know how well they will serve investors over the long term. But they could turn out to be industry trailblazers, a welcome development for fixed-income investors properly concerned about the prospect of losses when interest rates rise.

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