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Laurie King

Are bonds a risk in target date portfolios of near-retirees?

AdvantageVoice® Blog—5-8-13
Laurie King

Given the negative returns of target date portfolios belonging to people near retirement in 2008, much has been written about prudent levels of equity for those near retirement. However, if equity risk is a smaller portion of target date funds at retirement dates, then does that mean the bond portion now poses a substantial risk should interest rates rise? For an answer, we talked with Jim Lauder, CEO of Global Index Advisors.

Since interest rates remain near historic lows, it makes sense that interest rates will increase at some point. Can you give us your perspective on interest rates?
Interest rates have been at low levels for some time, longer perhaps than many thought possible. The 10-year Treasury yield has been less than 4% for more than four years, and it has essentially been below 2% for more than a year. Interest rates are reflecting the accommodative monetary policies of central banks around the world and global growth that is moderate at best and quite weak in other spots, notably Europe. So, while we do not think a sharp increase in interest rates is imminent, we do agree that interest rates are unlikely to move much lower. So, we are prepared for the next move, which we expect will be for higher interest rates eventually.

Your glide path for target date portfolios near maturity is one of the more conservative in terms of its equity risk exposure. Does that mean it has more bond risk?
Not necessarily. While we currently have more exposure to bond risk, or interest-rate risk, than many of our competitors, it is not necessarily true that we will have higher bond risk exposure going forward, for several reasons. First of all, our strategy is based on the Dow Jones Target Date Index methodology, which employs an asset allocation optimizer rather than a simple allocation among the main asset classes—equities, bonds, and short-term investments. 

In our case, the risk target of a portfolio for someone 10 years past their retirement date is conservative. To be precise, the Target Today Index has a risk target equal to 20% of the risk of the all-equity benchmark, with the condition that the actual equity allocation be within a 5% band in either direction of the targeted relative equity risk level (maximum of 25% equity and a minimum 15% equity). While that means that the maximum allowable bond allocation is 80%, based on a minimum 15% equity allocation and minimum 5% cash allocation, the optimizer can allocate as little as 5% to bonds under the right conditions. As interest rates rise and bond prices fall, the optimizer should begin to shift assets away from bonds and into our short-term investment portfolio, thereby shortening the overall duration of the target date portfolio and reducing the negative effect of rising interest rates on portfolio returns. While the optimizer will not eliminate bond risk, it does have the ability to soften the blow.

Can you explain this shift away from bonds and into short-term investments?
The optimizer utilized by the Dow Jones Target Date Indexes is designed to allocate to cash when bonds become too volatile or too highly correlated to equities. The optimizer builds an efficient portfolio of stocks, bonds, and cash at each targeted level of relative equity risk on the glide path. For example, the Target Today Index is designed to have 20% of the downside volatility of the global equity portfolio. The optimizer’s real job is to determine what combination of bonds and cash should be added to an all-equity portfolio to lower the risk of the three-asset portfolio to 20% of that of the all-equity portfolio. As the downside risk of bonds increases, which is generally what occurs in a rising interest-rate environment, the optimizer begins to view cash as a more attractive option than bonds for lowering portfolio risk and begins to add more cash and fewer bonds to achieve the 20% target risk level.

So there is a strategic purpose for short-term investments beyond providing liquidity?
Yes, definitely. We view cash as a strategic asset class that has unique investment merits. Historically, cash returns have tracked inflation fairly closely, trailing inflation by small amounts in some time periods and exceeding inflation in others. Cash, while it is not considered by many to be an attractive asset class, may actually act as a hedge against inflation. 

What are the other ways your target date strategy is designed to protect investors from rising rates?
Our exposure to foreign bonds can help dampen the effect of domestic interest-rate increases. Our strategy invests 25% of its bond allocation in international bonds, which acts as a hedge against domestic interest-rate risk because foreign rates do not usually move in lockstep with domestic rates. In fact, the correlation between our three equally-weighted domestic bond asset classes (government, corporate, and mortgage-backed) and the international bond asset class is only 0.53% based on monthly returns from January 1980 through March 2013.

Within the U.S. portion of our fixed income strategy, less exposure to U.S. government bonds relative to the Barclays U.S. Aggregate Bond Index can also help insulate investors from rising rates. That’s because U.S. government bonds, which have virtually zero default risk, are the bond asset class most affected by changes in interest rates, whether driven by inflation expectations or Federal Reserve actions. In addition, our strategy’s passive overweight to corporate bonds can help offset interest-rate risk because their returns are also influenced by changes in default risk. Since increases in interest rates typically occur when the economy is growing robustly, the effect of rising rates on corporate bonds can be partially offset by a decrease in the risk premium investors demand for nongovernment bonds.

The target date represents the year in which investors may likely begin withdrawing assets. Target date investments gradually seek to reduce market risk as the target date approaches and after it arrives by decreasing equity exposure and increasing fixed-income exposure. The principal value is not guaranteed at any time, including at the target date.

"Dow Jones®" and "Dow Jones Target Date IndexesSM" are service marks of Dow Jones Trademark Holdings LLC (“Dow Jones”); have been licensed to CME Group Index Services LLC ("CME Indexes"); and have been sublicensed for use for certain purposes by Global Index Advisors, Inc., and Wells Fargo Funds Management, LLC. The Wells Fargo Advantage Dow Jones Target Date FundsSM, based on the Dow Jones Target Date Indexes, are not sponsored, endorsed, sold, or promoted by Dow Jones, CME Indexes, or their respective affiliates, and none of them makes any representation regarding the advisability of investing in such product(s).

The views expressed are as of 5-8-13 and are those of Laurie King, Jim Lauder, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.

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