Target Retirement Funds: Built to weather many storms
July 25, 2013
With Vanguard Target Retirement Funds serving as staples of many retirement accounts, some investors may wonder what will happen to the most conservative part of their portfolios—bonds—as interest rates rise.
Vanguard experts acknowledge this concern but caution against overlooking the fact that the funds are designed to deliver for the long term.
For example, just a few years ago, similar questions arose about stocks in the portfolios of Target Retirement Funds during the financial crisis and stock market slump. At that time, people questioned whether the funds should have even a 30% allocation to stocks. Nonetheless, those allocations helped as the stock market rallied.
Catherine Gordon of Vanguard Investment Strategy Group said the key remains holding firm to a time-tested philosophy.
"We structure the funds to have an enduring investment case," she said. "While the funds aren't immune to market conditions, their diversification can serve as a buffer against extremes."
Ms. Gordon also noted that "just because something happens with bonds in a portfolio doesn't mean there is a carryover to the equity portion. To look at the fixed income portion in isolation is misleading, because you're missing an important piece."
A subdued outlook for bonds
Investments in target-date funds and Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in the Target Retirement Fund is not guaranteed at any time, including on or after the target date.
Interest rates in recent times were at historic lows and prices at corresponding highs, which means bond returns could be muted over the next few years.
Before exploring the outlook for bonds, however, key terms to keep in mind are yield to maturity and average maturity. Yield to maturity is the rate of return an investor would receive if the bonds held by a fund were held to their maturity dates. Average maturity means an average of the maturity dates for all securities in a bond fund. (The maturity date is the date that a bond buyer will be repaid by the security's issuer.) Therefore, an investor curious about what a bond fund might return through its maturity date can use its yield to maturity as an indicator.
Consider Vanguard Total Bond Market II Index Fund, in which the Target Retirement Funds invest. The yield to maturity on the Total Bond Market II Index Fund as of June 30, 2013, was 2.25% and its average maturity was 7.4 years. If Total Bond Market II Index Fund held all of its securities to maturity, then it could be expected to return 2.25% over the next 7.4 years.
The effect of this on the return of a particular Target Retirement Fund would depend on the percentage of its portfolio allocated to bonds; near-dated funds hold larger positions in fixed-income investments.
Alternatively, if an investor's focus is on risk rather than return, looking at a fund's duration can be a good indicator of how sensitive the fund's prices are to interest rate movements. For instance, if a bond has a duration of two years, its price would fall about 2% when interest rates rose one percentage point. On the other hand, the bond's price would rise by about 2% when interest rates fell by one percentage point.
A hypothetical example helps illustrate the point.
Vanguard Total Bond Market II Index Fund had an average duration of 5.4 years on June 30. So even if interest rates broadly rose 1% in one year—considered an unlikely occurrence—that fixed income portion of a Target Retirement Fund would be expected to lose a modest 5.4%.
"The fact that these portfolios are invested in a broadly diversified, intermediate-term fixed income fund suggests we've thought at length about preparing them for whatever comes the bond market's way," Ms. Gordon noted.
In addition, rising interest rates that lead to increasing bond yields is not necessarily a negative development for long-term investors. This is because, over time, higher rates translate to higher dividends on the funds, which will help to offset any capital losses.
Inaccurate predictions make diversification key
Trying to anticipate changes in interest rates can be as hazardous as trying to time the stock market.
The bond market has many components—bonds that mature over the short-, intermediate-, and long-term; bonds issued by governments; and bonds issued by corporations. These components don't all move in tandem, and they don't all react the same way to moves by the Federal Reserve.
And, unlike the 1970s when the Federal Reserve hiked rates to quash inflation, little inflationary pressure currently exists—so bonds may hold their value and continue to earn their current rate of interest for years to come.
Matt Brancato of Vanguard's Portfolio Review Department pointed out that precedent exists for a long period of low rates: The rate on 10-year U.S. Treasury notes remained below 4% for 35 years beginning in 1925.
So if no one knows when, how much, or how quickly rates may rise, this highlights the importance of a long-term strategic allocation to bonds in Vanguard Target Retirement Funds.
"The bottom line, we believe, is that bonds play an important role in a balanced portfolio as a diversifier," Mr. Brancato said. "Bonds still can provide valuable and relatively unique shock absorption in times of market stress."
- All investing is subject to risk, including the possible loss of the money you invest. Past performance is not a guarantee of future results. Diversification does not ensure a profit or protect against a loss.
- While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. While the market values of government securities are not guaranteed and may fluctuate, these securities are guaranteed as to the timely payment of principal and interest.
- Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.