As interest rates continue to hover near their all-time lows, many people are beginning to wonder when rates will rise and how that might impact their investments.
These days, a lot of attention has been focused on how higher interest rates might affect bond investments. While we’ve covered this topic on our blog, we are increasingly being asked how rising rates may impact target date funds (TDFs).
It’s a good question, especially for investors nearing retirement who are wondering what a rising rate environment may mean for their TDF. But first, let’s look at what we’ve seen historically when it comes to TDFs and rising rates.
History says: When rates rose, so did stocks
Investors choose TDFs so that they can take advantage of long-term correlations, or relationships, between asset classes, which tend to move in certain ways together over time. T
Target dates include equities to provide diversification against bonds, and vice versa. History has shown that it’s rare to experience a rise in rates without a rise in equities. As the chart below illustrates, the returns for stocks in a rising rate environment have generally been attractive not only during the period when rates went up but also in the subsequent 12 months.
For example, in 1981, Treasury rates experienced a significant rise, but equities also rallied and the markets went off on their long bull run. That’s correlation and diversification at work.
The target date funds for those nearing retirement, however, will typically have more bond exposure and fewer equities. But different providers position their funds’ asset allocation differently. Some funds may allocate about 60% of assets to bonds on their targeted maturity date, while others may allocate closer to 70%, or even 80%. Regardless of the allocation at maturity, TDFs include a percentage of upside equity potential to offset pressure on the bond side.
When we look at risk, we tend to look at many factors, including real rates, inflation, credit, economic and political risks, and liquidity. When we measure a portfolio risk exposure on those factors, as opposed to just capital, even with say, 53% bonds, only about 18% of the risk is coming from real rate exposure and about 13% from inflation, according to BlackRock data.
Potential to perform–in all markets
At the end of the day, the goal of TDFs is to help protect investors from potential bond losses by diversifying their investments across many other asset classes—mainly equities. Looking at the effect of rising interest rates on only one portion of a diversified portfolio provides an incomplete picture. T
arget date fund investors experience the return of all assets in the fund. If you have a diversified portfolio and historical correlations hold true, your portfolio should be well positioned for a scenario such as a rise in rates. We recommend talking to your financial advisor to better understand how your own portfolio is positioned.
Chip Castille, Managing Director, is head of BlackRock’s US & Canada Defined Contribution Group. BlackRock manages the iShares ETFs.