The timing of the U.S. Federal Reserve’s interest rate “liftoff” was a focal point of global economic and market news for most of last year. I was regularly asked by clients how they should be responding to this anticipated interest rate “liftoff.” Should they rethink their asset allocations? What will be the likely impact on their total portfolio as rates rise? Are recent retirees or those nearing retirement at risk? And can this risk be quantified? Are bond-heavy retirement income funds at risk?
Well, finally, that anticipated Federal Reserve increase of the fed funds rate occurred on December 16, 2015. Of course, with this move, bonds issued at lower interest rates than the ones available at the time of the rate rise will be worth comparatively less. More specifically, their prices will fall, so that the bonds’ total returns, on a forward-looking basis, equal the total return on new issues with higher interest rates. For example, if new 15-year bonds are being issued at 4% coupon payment, the price of a 15-year bond yielding 2%—to be competitive—must decline to a level that results in a 4% yield to maturity. In this example, that price is 77.76% of face value (or $777.60 per $1,000 face value). The 2% bond would provide the same return as the 4% bond at par, but some of the return would come from the bond’s appreciation from $777.60 to its $1,000 value at maturity, as opposed to the coupon payments.
Rather than staying focused on the value of a portfolio’s bonds themselves, or their broader role in a portfolio, investors have been concerned over the impending rise in very short-term interest rates and what the negative implications might be on their investment portfolios. Investors’ focus, or possible overreaction, to what might happen to their bond portfolio in a rising-rate environment may cause them to alter a well-diversified portfolio to one that is less diversified, more highly correlated to the equity market, or structured to potentially benefit from a rise in interest rates that never occurs.
This past January, I co-authored a paper titled “Rising interest rates: Weighing risk for TDF retirees” that provided an analytical framework to assess the potential impact of rising rates on Vanguard Target Retirement Fund in retirees’ portfolios. In this paper, we examined a simplified portfolio composed entirely of fixed income securities to illustrate the different levers that drive bond prices.
A bond portfolio that constantly buys new issues and experiences the maturation of older issues confronts two contrasting forces during a rising-interest-rate environment. On the one hand, the prices of existing bonds in the portfolio fall. On the other hand, the bond portfolio buys newer issues with higher yields. On a net basis, our findings suggest that a target-date-fund (TDF) investor with a time horizon longer than the portfolio’s duration may actually benefit from a rising-interest-rate environment. This is because an increase in interest rates benefits the long-term investor by providing an opportunity to incorporate bonds with higher interest rates over time. This effect overwhelms the short-term decrease in portfolio value caused by a rising-rate environment. Of course, timing matters, and not all investors can wait for the long term. Many variables can affect the success of a retirement portfolio. Spending from the portfolio and movements of interest rates are two major factors.
To analyze these variables, we first looked at a simplified scenario involving a hypothetical 100% fixed income portfolio whose bonds had a 7-year average maturity and an initial yield of 2.3%. The portfolio’s duration, a measure of the sensitivity of bond—and bond mutual fund—prices to interest rate movements, was 5.8 years. Duration can be used to measure the effect of bond-price volatility on a portfolio’s total return.
The chart below illustrates the change in hypothetical portfolio values (as a multiple of final-year salary before retirement) over time for a retiree, given various increases in interest rates. As shown, the portfolio value decreases as interest rates rise over the first four years of retirement, and then the portfolio begins to recover because the portfolio benefits from the higher-yielding bonds purchased within a six-year window and, assuming a continuation of the same drawdown strategy used at the beginning of the time horizon, recovers to the full portfolio value within six years.
In fact, the diversification benefit, resulting from more-certain bond coupon payments leading to lower volatility, is exactly why bonds are used in a portfolio. A bond’s nominal total return through maturity in the absence of default is known in advance. In contrast, no one can predict with certainty what the equity returns (including dividend payments) in a rising-rate environment will be. Stock volatility can increase as a result of changes in both company fundamentals and investors’ perception of factors that may affect those fundamentals. Of course, the trade-off is that stock fund holdings can potentially generate more upside return than can bond funds.
The cause of an interest-rate rise is essential to understand, such as whether the markets expected the rise, 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 such as a TDF, mainly because equities typically do well in such an environment. 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. It’s important to understand that a rising-interest-rate environment may not be the traumatic event for an investor’s portfolio that many investors seem to believe it is.
Investments in bonds are subject to interest rate, credit, and inflation risk.
Diversification does not ensure a profit or protect against a loss.
All investing is subject to risk, including the possible loss of the money you invest.
Investments in 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 work force. 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.