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Look Out for Bond Risk in Target Date Funds

Capital Group®, home of American Funds® 

Key takeaways:

  • Ultra-low interest rates have fueled a rise in BBB issuance and a reach for yield.
  • This trend could be raising risks in some target date funds, especially for older investors.

Millions of investors rely on their target date funds to not only help grow wealth, but preserve that wealth during bouts of market volatility. Traditionally, target date providers have relied on high-quality bonds to help provide this balance.

But credit quality can vary significantly within these funds’ bond exposure, even within investment-grade credit (rated BBB/Baa and above). Investment-grade bonds of lower credit quality have tended to fare worse in equity-market downturns. And the risk could be rising in today’s uncertain economic environment, given increased corporate leverage and a rise in lower quality bond issuance.

While this presents downside risks to all participants, investors closer to or in retirement are particularly vulnerable. To evaluate a series’ potential to cushion downturns, plan sponsors may want to closely examine their series’ fixed income portfolio— both in isolation and in relation to the equity portion of the glide path.

An abundance of riskier credit

Ultra-low interest rates have led some investors to extend down the credit spectrum in search of yield. As a result, lower quality issuance has surged in the investment-grade market. Indeed, credits in the lowest rung of investment-grade now make up nearly one-half of the total U.S. investment-grade corporate bond market, according to J.P. Morgan. That’s up from a low of about 20% in 1992.

And while these bonds do generate higher income, they behave more like equities when it comes to risk. For example, during the first-quarter equity selloff, BBB bonds (the lowest rung) posted a –7.39% return, according to an analysis of the Bloomberg Barclays U.S. Aggregate Index. In contrast, the AAA portion of the index posted a 5.81% gain. Although good security selection can help overcome this vulnerability, these lower quality bonds also risk becoming “fallen angels” via rating downgrades — potentially exposing investors to further losses.

BBB bonds have lagged in corrections

This bar chart shows cumulative returns for eight asset classes during the first quarter of 2020 and averaged over the most recent seven U.S. equity-market corrections (spanning from April 23, 2010 through March 23, 2020). For each asset class, the left dark-blue bar shows the cumulative return for the first quarter of 2020. The right light-blue bar shows the seven-correction cumulative return average. Here are the cumulative returns for the first quarter of 2020 and the seven-correction average, respectively, for each asset class: For the S&P 500,  -19.60% and -17.45%; for U.S. aggregate bonds, 3.15% and 1.42%; for U.S. government bonds, 8.08% and 3.23%; for AAA bonds, 5.81% and 2.41%; for AA bonds, 1.48% and 0.73%; for A bonds, -0.56% and -0.33%; for BBB bonds, -7.39% and -2.41%; and for high-yield bonds, -12.68% and -7.26%. Source: Capital Group, using data from Morningstar and Bloomberg, as of March 31, 2020. Returns are cumulative. Average based on the seven most recent U.S. equity-market corrections, defined as between a 10% and 20% price decline (peak to trough) of the Standard & Poor’s 500 Composite Index.

Check for interactions

As a result of BBB’s history of increased risk, plan sponsors may want to take a closer look at the credit quality of target date funds. For example, a passive series tracking major bond indices could have seen its BBB exposure increase alongside the broader market. An actively managed series may have also taken on more credit risk by investing in lower quality investment-grade credits in a reach for yield.

We saw this trend when examining the BBB exposure of the four largest 2025 target date funds by mutual fund assets. As of June 30, the sole passively managed fund in that group had 20.8% of its fixed income assets in BBB bonds — up from just 15.2% five years earlier. Among the other three, actively managed funds, BBB exposure varied a lot — ranging from 9.5% to 19.8%, according to Morningstar data.

To be sure, exposure to high-yield and BBB-rated bonds is not always problematic. Yet, the big risk comes when these bonds are paired with an equity-heavy glide path, especially near retirement. This combination of more volatile assets can impair a target date fund’s ability to cushion market declines.

Questions to evaluate risk

When evaluating a target date series, plan sponsors should consider the underlying bond risk and how that risk integrates with equities — particularly in vintages in and near retirement. Ask questions such as:

  • What is the mix of investment-grade credit, high-yield and government bonds throughout the glide path?
  • How does the exposure to BBB bonds vary over time?
  • How much equity is being used alongside BBB and high-yield bonds?

These questions will become more important as millions of participants near retirement and become more sensitive to downside risk.  

To learn more about credit risk in target date funds, download our white paper. Use our Target Date ProView comparison tool to see how different target date providers approach fixed income.

The return of principal for bond funds and for funds with significant underlying bond holdings is not guaranteed. Fund shares are subject to the same interest rate, inflation and credit risks associated with the underlying bond holdings. Higher yielding, higher risk bonds can fluctuate in price more than investment-grade bonds, so investors should maintain a long-term perspective.

Bond ratings, which typically range from AAA/Aaa (highest) to D (lowest), are assigned by credit rating agencies such as Standard & Poor's, Moody's and/or Fitch, as an indication of an issuer's creditworthiness.

Although the target date portfolios are managed for investors on a projected retirement date time frame, the allocation strategy does not guarantee that investors' retirement goals will be met.

Bloomberg Barclays U.S. Aggregate Index represents the U.S. investment-grade fixed-rate bond market. This index is unmanaged, and its results include reinvested dividends and/or distributions but do not reflect the effect of sales charges, commissions, account fees, expenses or U.S. federal income taxes.

Standard & Poor’s 500 Index is a market capitalization-weighted index based on the average weighted results of approximately 500 widely held common stocks. This index is unmanaged, and its results include reinvested dividends and/or distributions but do not reflect the effect of sales charges, commissions, account fees, expenses or U.S. federal income taxes.

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.

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This content, developed by Capital Group, home of American Funds, should not be used as a primary basis for investment decisions and is not intended to serve as impartial investment or fiduciary advice.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and should not be considered advice, an endorsement or a recommendation.

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