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Rising interest rates pose issue for target-date mutual funds

Funds geared toward long-term goals such as retirement that automatically shift into more fixed-income investments over time may lose value as rates rise.

April 05, 2013|By Walter Hamilton, Los Angeles Times

The appeal of age-based mutual funds is that investors generally don't have to worry about them.

The funds are geared toward long-term goals such as retirement or a child's college education, and automatically shift into more conservative holdings over time. That normally means selling stocks and buying bonds.

Today's ultra-low interest rates, however, pose a challenge for investors in these funds.

As the U.S. economy gains steam over time, interest rates are likely to rise. And when they do, it's possible that fixed-income investments could decline in value.

This is potentially a big threat for bond-only funds, but also an issue for age-based, or target-date, funds, which combine stocks and bonds, experts say.

The issue is most pressing for funds that are nearing their goal and have a higher percentage in fixed-income investments. It may be most acute for parents saving in 529 college plans.

Because a child's college career is much shorter than retirement, parents have less time to recoup investment losses. And 529 plans typically have large helpings of bonds, especially the closer a child gets to college.

For example, Vanguard's "moderate growth" 529 plan, designed for parents of children ages 11 to 15, has 75% of its assets in bonds. A 2% rise in interest rates could cause the fund to drop almost 8%, according to Vanguard.

Investors shouldn't necessarily tweak their portfolios because of the specter of rising rates, experts say. The effect on individual funds could vary significantly based on factors such as portfolio composition and the speed with which rates rise.

More important, there's no obvious alternative, experts say. In general terms, investors who lighten up on fixed-income investments can either increase their holdings of stocks or money-market funds. Both carry obvious risks.

"Wherever you go you're giving something up in terms of safety or return potential," said John Miller, head of retirement at Pimco.

"If the question is, 'Should people be worried about a rise in rates?' The answer is, 'Yes,'" Miller said. "But the question then becomes, 'What magnitude loss are you looking at versus equities or other more volatile asset classes?'"

Nevertheless, investors should beware of the potential damage from rising rates and understand how the funds they own are handling it, experts say.

"It's definitely something to think about," said Josh Charlson, an analyst at Morningstar Inc.

Concern about the effect of rising rates is a relatively new issue because steadily falling rates over the last three decades have been a boon to fixed-income investors.

As rates decline from, say, 4% to 3%, the older 4% bond is worth more. Thus, a generation of bond investors has benefited from both interest payments and capital gains.

The reverse, however, is also true. As rates rise from historically low levels, investors holding older, lower-yielding bonds could suffer capital losses.

Target-fund managers say any fixed-income losses would be mitigated by the rest of the portfolio.

For example, the fixed-income portion of the Vanguard 2015 target-date retirement fund would lose 5.28% of its value if interest rates rose 1%, according to the fund company. But because bonds make up only 46% of the portfolio, the fund's overall loss would be just 2.41%.

More important, managers say, a rise in rates probably would be caused by a pickup in the economy. That growth, they say, could spur a rise in the stock portion of a portfolio that outweighs a loss in fixed income.

"It's very rare that you get a rise in rates without a corresponding rise in equities," said Chip Castille, head of the U.S. and Canada defined-contribution group at BlackRock.

Equally important, no one knows when rates will rise.

Talk of a so-called bond bubble — in which rates could violently reverse course — has percolated for the last several years. But rates have defied predictions and generally headed even lower.

"People have been expecting rates to rise for a long time, and anyone who tried to set their clock by it would have been wrong many times," said Catherine Gordon, a principal at Vanguard. "Timing interest rates is just as difficult as timing the stock market."

And the impact could be softened by an expectation among many experts that rates would climb slowly over time.

Investors can gauge the effect on a specific fund by assessing its duration, which measures a portfolio's sensitivity to rate movements.

Duration is expressed in years. In simple terms, multiply the fund's duration by the increase in rates to approximate the potential loss. A 1% pickup in rates would cause a fund with a duration of five to drop 5%.

Some funds have taken steps, such as buying shorter-term bonds, to lower the duration of their funds.

Another key for investors is determining how much time they have. Rising rates, of course, mean higher interest payments. And over time, increased payouts counterbalance capital losses.

If rates rose 2% in a year, the Vanguard total bond market index fund, a key component of its target-date funds, would drop 8%. Investors would recoup that within four years, when the fund's total return would rise to 2.1%.

"Rising rates at some point are a good thing because you're getting the higher interest rates," Gordon said.

walter.hamilton@latimes.com

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