Target date fund investors can’t see the forest for the trees, too often fixated on interest rate risk and missing the value of the portfolio’s bonds themselves or the broader role they play in a portfolio.
A recent report from Vanguard, titled “Rising interest rates: Weighing risk for TDF retirees” notes that “bonds are a unique and important diversifier in a balanced portfolio, precisely because their expected yield and future value are mathematically determined.”
It goes on to state that as interest rates rise, the current value of a bond portfolio will be worth less because higher-yielding bonds can be purchased in the market than the ones owned in the portfolio.
However, it adds that over time, as these newer, higher-yielding bonds are added to a bond portfolio, the investor can benefit.
“The time horizon to realize this benefit is similar to that of the average duration of the portfolio’s bonds,” the report’s authors note. “It’s important to understand that a rising interest rate environment may not be the traumatic event to an investor’s portfolio that many investors seem to believe.”
It emphasizes that the cause of the rate rise is essential to understand, such as whether the rise was expected by the market, the timing of the rise, and the economic factors involved.
“Interest rate movements that coincide with economic growth generally can be expected to provide a positive long-term portfolio impact for an investment like a TDF, mainly because equities typically do well in such an environment,” the report concludes. “In contrast, interest rate movements associated with runaway inflation expectations can be detrimental to portfolio returns, primarily because equities and bonds tend to do poorly in that type of environment.”
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
