Interest rates have had a bumpy ride lately, that’s for sure. After hovering for years at historically low levels, 10-year U.S. Treasury yields started climbing in late 2016 and have been trying to hold onto upward momentum since—however haltingly. For its part, the Federal Reserve has been cautiously raising the federal funds rate. Both have led to a lot of discussion and concern about the appropriate level of interest rate risk, or duration1, in target-date funds—particularly with those funds for older participants approaching or in retirement, where there’s a larger exposure to fixed income than in funds for younger participants.

Please understand, I’m not saying this concern about interest rates is misplaced—it isn’t. But while plan sponsors fret about interest rate risk in target-date funds, they shouldn’t lose sight of the greatest risk to participants—and it’s not fixed income. It’s the risk from a plan’s equity exposure.

While rising interest rates can create negative returns in bonds (particularly for longer-duration bonds), the magnitude of potential losses is unlikely to be anything close to a bear market in equities, as Figure 1 illustrates. Historically, stocks have had far more downside risk than bonds, with negative returns in more than 25% of the 12-month return observations. In 6% of observations, they experienced a bear market, which is defined as a loss greater than 20%. Bonds, on the other hand, have realized negative returns in a little more than 15% of observations and have never experienced a bear market of that magnitude in the United States. In fact, a loss of greater than 10% is an event so rare, it’s only happened in 2 of the almost 1,100 12-month return observations that we examined. Compare this with stocks, where a more-than-10% loss has happened more than 13% of the time. Big difference.

Figure 1:  The risk of loss is far greater in stocks than in bonds

Rolling 12-month performance, 1927–2016.












When determining which index to use and for what period, we selected the index that, in our view, best represented the characteristics of the referenced market, given the information then available. Thus, U.S. stock market represented by Standard & Poor’s 90 from February 1926 through March 3, 1957; S&P 500 Index from March 4, 1957, through 1974; Wilshire 5000 Index from 1975 through April 22, 2005; and MSCI US Broad Market Index thereafter. U.S. bond market represented by S&P High Grade Corporate Bond Index from 1926 through 1968; Citigroup High Grade Index from 1969 through 1972; Lehman Brothers U.S. Long Credit AA Index from 1973 through 1975; Barclays U.S. Aggregate Bond Index from 1976 through 2009; and Bloomberg Barclays U.S. Aggregate Float Adjusted Bond Index thereafter.

Source: Vanguard.

But what, some may ask, if this time is different? Boy, if I had a nickel for every time I’ve heard that… Is it possible? Sure, but not likely. Vanguard’s economic outlook forecasts only modest increases in short- and longer-term interest rates, with federal funds staying below 2% through 2018. We also believe that the fair value of the 10-year U.S. Treasury note has a yield of about 2.5%, very close to where it resides today. So, our forecast calls for only modest increases in interest rates that aren’t enough to generate large negative returns for bonds.

Now, I agree: The absence of unusually negative returns is hardly a ringing endorsement for investing in any asset class, let alone one that has a low-return outlook. So why bother investing in bonds at all?

The simple answer is that we believe bonds remain the best defense against a bear market in stocks. Figure 2 shows why, illustrating what’s happened in bear market environments where U.S. stocks on average decline by more than 7% per month, while high-quality bonds typically act as a counterbalance.

What’s really important to note is that the U.S. Treasury and longer-duration segments of the bond market have been particularly rewarding, on average, during these periods. Shorter-duration bonds also delivered positive returns, but it’s U.S. Treasury, intermediate-, and long-term bonds that historically have been the best performers in bear markets for equities. Incidentally, these are the same bonds that some observers claim are the riskiest part of target-date funds right now!

Figure 2:  Median returns of various asset classes during the worst decile of monthly equity returns, 1994–2016

U.S. stock market represented by Wilshire 5000 Index from 1944 through April 22, 2005; and MSCI US Broad Market Index thereafter. U.S. bond market represented by Barclays U.S. Aggregate Bond Index from 1994 through 2009; and Bloomberg Barclays U.S. Aggregate Float Adjusted Bond Index thereafter. International bonds represented by Bloomberg Barclays Global Aggregate ex-USD index hedged index; high-yield bonds by Bloomberg Barclays U.S. Corporate High Yield Index; Treasury bonds by Bloomberg Barclays U.S. Treasury Index; emerging market bonds by Bloomberg Barclays Emerging Markets USD Sovereign Bond Index; Short-Term Bonds by Bloomberg Barclays U.S. Aggregate 1-3 years index; Intermediate-Term Bonds by Bloomberg Barclays U.S. Aggregate 5-7 years index; and Long-Term Bonds by Bloomberg Barclays U.S. Aggregate 10+ years index.

Source: Vanguard.

I hope you can see why we at Vanguard believe that the biggest market-related risk in target-date funds isn’t bonds—it’s stocks. This belief extends to the most conservative target-date funds, where equity allocations typically run between 30% and 50% of the portfolio. And it’s especially true today, when we’re eight years into an equity bull market and every valuation metric for equities is above historical averages.

These facts don’t mean a bear market in equities is imminent, because bull markets don’t just die of old age and above-average valuation multiples can increase even further. But they should serve as a reminder to plan sponsors of where the real market-related risk in their target-date funds lies—and it’s not in their bonds.

It’s also a healthy reminder that the types of bonds matter. Shortening the duration of your fixed income exposure and/or overweighting corporate bonds at the expense of U.S. Treasuries may leave your target-date funds underexposed to the very bonds that have delivered the best results in equity bear markets.

Naturally, we all need to pay attention to the various risk exposures in our target-date funds. But please, don’t let the prospect of rising interest rates make you lose sight of why it’s so important to invest in bonds: the benefits of diversified portfolio construction and the larger downside risk in equities.    

1 Duration is a measure of the sensitivity of bond—and bond mutual fund—prices to interest rate movements. Investment-grade is a rating that indicates that the level of default of the bonds in the portfolio is relatively low.

2 When we refer to bonds, we mean the entire investment-grade bond market (or the Bloomberg Barclays US Aggregate Index); when we refer to stocks, we refer to the U.S. stock market.


  • All investing is subject to risk, including the possible loss of the money you invest.
  • Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
  • Diversification does not ensure a profit or protect against a loss.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.  These risks are especially high in emerging markets.
  • Investments in target-date 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 workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in target-date funds is not guaranteed at any time, including on or after the target date.