Friend or foe? The role of duration in target-date funds

Interest rates and bond prices move inversely: When rates fall, prices rise; and when rates rise, prices fall. How much a bond’s price rises or falls depends on the bond’s duration, measured in years. The longer the duration, the greater the price volatility associated with interest-rate moves in either direction.

For target-date fund investors who have many years to go until retirement, long duration bonds can help provide robust and welcome protection from short-term equity market shocks in the early stages of the glide path. However, the merits of adding longer duration assets for protection can reverse—leading to heightened interest-rate risk—if duration isn’t controlled nearer to—and through—an investor’s retirement.

The negative correlation that has existed between U.S. Treasury bonds and broader equities over the past 30 or so years is well known, and essentially provides the case for longer duration assets to be used as a buffer against market drawdowns.

When equities sell off in a crisis, central banks often step in, buying fixed-income assets and targeting lower reserve borrowing rates to—and among—banks in an attempt to reduce short-term interest rates. Treasuries often rally as investors flee from equity volatility into high-quality bonds, further lowering and flattening the yield curve. In these environments, where short-term market shocks often lead to rapid rate cuts, the market value of long duration bonds tends to rise, giving investors valuable protection against volatile markets.

S&P 500 Index, 10-year U.S. Treasury bonds, long duration STRIPS, October 1997–March 2020 (returns %)

Source: Bloomberg, Manulife Investment Management, January 2022. STRIPS refers to Separate Trading of Registered Interest and Principal of Securities. STRIPS are underwritten by the U.S. government. Long duration STRIPS returns are represented by ICE BofA Long U.S. Treasury Principal STRIPS Index, which tracks the performance of long maturity STRIPS representing the final principal payment of U.S. Treasury bonds. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. 10-year U.S. Treasury bond returns are represented by the ICE BofA 10-Year U.S. Treasury Index, which is a one-security index, rebalanced monthly, comprising the most recently issued 10- year U.S. Treasury note. It is not possible to invest directly in an index. 

Portfolios often seek broad bond market exposure through allocations to the Bloomberg U.S. Aggregate Bond Index (Agg), which tracks the performance of U.S. investment-grade “core” bonds. However, several of the Agg’s components—namely corporate bonds and mortgage-backed securities—have a higher correlation to equities than Treasury bonds. It also has a relatively modest average duration. So while the Agg has merit for broad bond exposure, it’s less effective as a tool for adding protection through duration.

That job may be done more efficiently by STRIPS—Separate Trading of Registered Interest and Principal of Securities—where interest and principal payments have been stripped apart from whole Treasury bonds and sold separately at a discount. Long STRIPS offer the longest duration possible within the Treasury bond market. And as they’re still backed by the U.S. government, they remain a high-quality debt instrument.

STRIPS can be found with durations of 25.0 years or more, compared to around 6.6 years at the time of writing for the Agg, and approximately 18.3 years, on average, for long duration Treasury bonds. This makes them highly efficient, requiring low levels of capital allocation to pursue optimal levels of potential portfolio protection.

From an investment standpoint, rising inflation is a risk that requires careful and constant monitoring. Higher inflation levels can quickly erode capital growth, reducing an investment’s value in real terms. TIPS—Treasury Inflation-Protected Securities—are a useful portfolio tool to help provide inflation protection since they come with the benefit of compensation by the Treasury whenever inflation rises.

However, as every investor should know, there’s no such thing as a free lunch. Although TIPS may be effective at helping to reduce inflation risk, the underlying Treasury bonds can introduce interest-rate risk to a portfolio. Should inflation rise to a level not anticipated by the market, causing short-term interest rates to rise and yield curves to steepen, duration exposure could cause TIPS to possibly lose more on the interest move than they gain from the potential inflation protection. To help manage this risk, short duration TIPS of one to three years may provide inflation protection while aiming to avoid adding significant amounts of duration risk.

Managing both inflation and duration through a glide path becomes particularly important when a fund starts to derisk, a process that can cover an extended period.

Source: Manulife Investment Management, January 2022. For illustrative purposes only. Not indicative of any fund.

Early on in a glide path, around 90% of a portfolio is invested in equities. Here, a modest allocation to STRIPS—less than 5% of total portfolio—provides meaningful potential protection from market drawdowns while keeping overall portfolio duration relatively low at just over one year. 

Source: Manulife Investment Management, January 2022. For illustrative purposes only. Not indicative of any fund.

As equity allocations reduce closer to retirement age, long duration STRIPS exposure is moderately increased to help provide portfolio protection against potential equity market downturns during the initial derisking phase. Overall portfolio duration is also increasing naturally at this derisking phase as fixed-income assets are increasing as a percentage of the total portfolio.

Asset allocation shifts are made to—among other things—manage the dual aspects of long duration STRIPS that have been added for potential protection, and increasing allocations to fixed income that’s helping to derisk the portfolio and generate income:

• Fixed-income exposures become more diversified, including increasing allocations to income-generating assets to support postretirement distributions.
• In particular, shorter duration fixed-income assets are layered in, such as near-maturity corporate bonds and bank loans for income generation, and real assets and real estate for both income generation and potential inflation protection.
• Short-term TIPS are added with the aim of providing potential portfolio inflation protection.
• STRIPS exposure will be reduced to zero by retirement (age 65). Total portfolio duration will reduce and remain marginally above three years.

Longer duration assets may be a powerful buffer against equity market shocks, but can also add higher interest-rate risk to a portfolio, which requires careful management. An increasing interest-rate environment—as is broadly expected in the current market environment—may ordinarily point to less effective conditions for long duration assets. However, our macro views suggest a prolonged lower-rate environment on a relative basis, supporting the case for at least a modest allocation to STRIPS, and a reasonable allocation to TIPS to help provide both tail risk and potential inflation protection.

As an active manager of target-date funds, we constantly analyze portfolios from multiple perspectives—two of which are duration and inflation—to ensure that investors not only benefit from the broader opportunities available across multiple asset classes, but that unintended investment risk is identified, and prudently managed. In this regard, and considering the market cycle ahead, flexibility and maneuverability remain key to managing portfolio risks and finding meaningful opportunities for target-date investors across the asset class spectrum.