How Will Rising Interest Rates and Inflation Impact Target-Date Funds?

After nearly seven years of zero-interest-rate policy, the Federal Reserve has begun lifting rates once again. That’s good news for savers who are looking to get better returns on their CDs and savings accounts, but it can be more of a mixed bag for holders of target-date fund shares.

In this article, we’ll examine how changes in interest rates and inflation expectations can impact the performance of target-date funds.

How Target-Date Funds Operate

To provide a bit of background, target-date funds give investors an all-in-one investment option that provides an allocation to equities, fixed income and cash that’s appropriate for when they’ll need the money in the future. These funds generally start with a heavier allocation to stocks when the target date is many years away and gradually add more conservative fixed-income securities to the portfolio as the target date nears. These funds have become very popular in employer-sponsored retirement plans and many providers set their allocations and glide paths according to the demographics of their employee base.

An important thing to note here is that not all target-date funds are equal. Investors should examine the asset allocations and glide paths of the funds they are considering to make sure they’re consistent with their own objectives and risk tolerances.

Check out our Retirement Income Funds section to know the different types of pre-packaged target-date funds.

When judging how interest rate fluctuations affect TDFs, it’s important to consider the entire picture as changes to rates affect both stocks and bonds. Many are familiar with the general inverse relationship between bond prices and interest rates. However, the credit quality of the bond, the currency in which it’s denominated and the length of time until maturity will impact the bond’s value uniquely.

You can read more about how target-date funds work to familiarize yourself with this class of mutual funds.

Impact of Rising Rates on the Fixed-Income Component of TDFs

The value of bonds within a portfolio generally fall as interest rates rise. Near-term target-date funds such as Fidelity Freedom 2020 (FFFDX) that have larger fixed-income allocations may be especially impacted by rising rates.

Check out the questions that you should ask your target-date fund provider.

Different types of bonds, however, behave differently. High-quality bonds – such as U.S. Treasury and investment-grade corporate bonds – and long-term bonds tend to be more interest-rate sensitive. These effects can be at least partially offset by holding a wide variety of bond types.

• Emerging market bonds – Securities from emerging nations tend to have low correlations with developed country bonds and can provide diversification benefits.

• Floating rate bonds – These notes usually are minimally affected by interest rate movements since their rates are automatically adjusted to reflect the current environment.

• High-yield bonds – These bonds are issued by companies that are financially distressed. Their value tends to be impacted more by the health of the issuer than the direction of interest rates.

Impact of Rising Rates on the Equity Component of TDFs

Interest rates impact how much companies have to pay to service their debt. Rising rates can lead to increased borrowing costs and that, in turn, can hurt profitability and ultimately the company’s stock price.

In general, higher interest rates can impact how attractive equities look. As rates rise, investors may be persuaded to move from stocks over to higher-yielding bonds. This “flight to quality” can hurt stock prices as selling pressure increases. On the other hand, interest rates tend to rise during periods of economic expansion and growth. Historically, equities have performed well during rising rate environments as economic strength tends to lead to increasing revenues and net income.

Be sure to follow our Target-Date Funds section to make the right investment decision.

How Investors Can Adjust Their TDF Strategies

If you’re concerned about how rising interest rates or inflation might impact your TDF, consider one of the following simple strategies.

• Look for funds with short-duration bonds – Duration is a measure of how much a bond’s price is expected to move given changes in interest rates. Choosing TDFs that contain shorter-duration bonds helps limit the impact of rising rates. The American Funds Retirement Income Portfolio – Conservative Fund (NAARX) is an example of a fund that meets these criteria.

• Consider customized TDFs – Whereas traditional TDFs provide a standardized glide path, a customized fund can give its investors something that’s more aligned with their personal goals and allows them more say over how assets get invested.

• Choose actively managed TDFs – Passively managed funds get most of the attention, but some TDFs, such as the American Century One Choice 2020 fund, are actively managed. This allows the fund to position itself appropriately in response to adverse market conditions.

• Look for TDFs that include TIPS – Treasury inflation protected securities have their principal value tied to the consumer price index (CPI), or the inflation rate. As inflation rises, the principal balance of the TIPS rises. It’s an easy way to protect your fixed-income portfolio if you feel this rate will increase. The Dimensional Retirement Income Fund (TDIFX) is a fund that makes a large investment in TIPS.

The Bottom Line

Investors don’t need to fear rising interest or inflation rates. Simple portfolio adjustments can often help protect target-date fund balances against certain market forces and keep your investment goals on track.

Be sure to check our News section to keep track of weekly fund performances.