Perspectives : Investment | August 25, 2022

Rising rates: Can TDFs handle the headwinds?

A rising-rate environment can be unnerving for target-date investors with large bond allocations. An all-weather approach is key to riding out the storm.

Target-date funds (TDFs) rely upon bonds to act as ballast while providing a steady source of income. But with high inflation and rising interest rates causing bond prices to tumble, some investors might wonder if the asset mixes in their TDFs are doing enough to reduce volatility in their retirement savings.

At Vanguard, we design our Target Retirement Funds for all types of economic and market conditions. In this article, we’ll take a closer look at the impact of rising rates on TDFs and discuss why our all-weather approach continues to offer one of the best opportunities for investors to achieve their retirement outcomes/goals across all market environments.

Rising rates don’t negate the benefits of bonds

In early May, the yield on the benchmark 10-year Treasury note climbed above 3%, which was more than double what it was just six months previously.

It’s hard to believe it was only a short time ago that plan sponsors were asking "Why Bonds Still Matter in a Low-Yield World". Just as quickly, the conversation has shifted to how bonds fit into the equation in an environment where inflation and rates are rising. Yet the case for bonds remains as valid today as when rates were hitting all-time lows―underscoring the versatility of bonds to deliver their intended benefits to investors regardless of market conditions.

An all-weather approach to TDF design

Because market trends can and do change over time, Vanguard builds its Target Retirement Funds using an all-weather approach to portfolio construction and asset allocation that avoids the need for tactical shifts based on short-term market environments. Our methodology focuses on providing investors the broader strategic benefits of different asset and sub-asset classes to help them achieve their long-term investment goals regardless of market cycles, inflation, and changes to interest rates.

Still, it can be tempting during periods of volatility to anchor expectations to recent events as a barometer for how markets will behave in the future. Even when short-term losses make tactical shifts in allocation seem compelling, they should not drive changes in target-date portfolio construction. Often, such reactive shifts can leave a portfolio inappropriately allocated for the market environment that follows.

Rising rates can lead to higher total returns for bond investors, so long as their investment horizon is longer than the duration of their bond portfolio.¹

Silver lining in the cloudy skies for bond investors

There’s no sugarcoating the fact that the first half of 2022 was painful for bond investors. The U.S. bond market fell about 11%, having posted one of its worst declines on record over the first six months of the year. Despite the steep losses, there’s a silver lining ahead: Rising rates could benefit bond investors over the long term. It may not feel that way now, but the higher income streams from today’s higher-paying bonds could help replenish recent short-term losses and leave investors better off than before.

To understand why, it’s helpful to consider the relative importance of interest income compared with price movements when calculating the total return of bonds (Figure 1).

Figure 1: Interest income drives bond total returns

Notes: Monthly data are from December 31, 1999, to March 31, 2022. U.S. aggregate bonds are represented by the Bloomberg U.S. Aggregate Index in USD. All bond income is assumed to be reinvested. The performance data shown represent past performance. Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Source: Bloomberg.

Figure 2: The correlation between stocks and bonds has been broadly negative since 2000

Correlation data are through March 31, 2022, and represent the relationship between U.S. equities and U.S. Treasuries. The correlations were calculated using daily market pricing at close of trading for the S&P 500 Composite Total Return Index and the S&P U.S. Treasury Bond Current 10-Year Total Return Index.

Source: FactSet.

The compounding effect of reinvested income means the total return from bonds depends far more on the income they generate than any changes in their face value. In fact, income has accounted for more than 90% of the average annual return of the U.S. bond market over the past two decades.2

For TDF investors, the income payments they’re earning from today’s bonds are being automatically reinvested in higher-paying bonds; over time, they could earn a higher total return from their bond portfolios than if rates had remained unchanged.

The counterbalancing force of bonds

While interest income is an important reason for holding fixed income, we believe the primary role of high-quality bonds in our Target Retirement Funds is not to produce high returns but to act as ballast in times of equity market stress.

Historically, investment-grade bonds have helped stabilize portfolio returns because of their negative correlation with equities. Recently, stock and bond returns have been more correlated, leading some observers to speculate if bonds can still dependably absorb the same level of equity volatility going forward.

Despite recent evidence suggesting stock and bond market movements have been more correlated, Vanguard research shows the relationship between equities and bonds has remained broadly negative since the early 2000s (Figure 2).

It has persisted through high- and low-interest rate environments, across full market cycles, and during times of significant financial shock―including the 2008 global financial crisis when stocks worldwide sank an average of roughly 34% and investment-grade bonds returned more than 8%. Similarly, from January through March 2020—the period encompassing the height of volatility in equities because of the COVID-19 pandemic—stocks fell by almost 16%, while bonds worldwide returned a little more than 1%. And if we look back even further, from January 1988 through November 2020, whenever monthly equity returns were down, monthly bond returns remained positive about 71% of the time.3 Figure 3 illustrates that during the worst decile of U.S. equity returns from January 1988 through March 2022, high-quality fixed income acted as ballast, cushioning the losses in the equity portion of a portfolio.

The relationship between stocks and bonds when rates are rising

The dynamics affecting asset correlations are complex, but a key driver is if economic growth and interest rates are moving in the same direction. When they are both positive, the correlation between stocks and bonds tends to be negative.4

If interest rates rise when the economy is cooling, as has been the case recently, bonds and equities tend to be more positively correlated. Additionally, while inflationary shocks can cause this correlation to increase further, growth and volatility shocks have the opposite effect―ultimately resulting in a lower correlation between asset classes and amplifying the diversification benefits of bonds.

Figure 3: Median return of various assets during the worst decile of monthly U.S. equity returns from January 1988 to March 2022

Notes: U.S. stocks represented by Dow Jones U.S. Total Stock Market Index; international stocks by MSCI AC World ex USA Index; REITs by FTSE NAREIT Equity REIT Index; dividend stocks by Dow Jones U.S. Select Dividend Index; commodities by Bloomberg Commodity Index; high-yield bonds by Bloomberg U.S. Corporate High Yield Bond Index; emerging markets bonds by Bloomberg EM USD Sovereign Index; corporate bonds by Bloomberg U.S. Corporate Index; Treasury bonds by Bloomberg U.S. Treasury Bond Index; international bonds by Bloomberg Global Aggregate ex-USD Bond Index; U.S. municipal bonds by Bloomberg Municipal Bond Index; and U.S. bonds by the Bloomberg U.S. Aggregate Bond Index. The Dow Jones U.S. Select Dividend Index starts in January 1992; Bloomberg EM USD Sovereign Index starts in January 1993; and Bloomberg Global Aggregate ex USD Bond Index starts in January 1990. All data provided through March 31, 2022.

Thinking about the current market, we expect inflationary concerns will continue to elevate the correlation between equities and bond returns, but only modestly. It’s worth noting that much of the concern surrounding inflation is based on recent year-over-year figures, whereas our research indicates the 10-year inflation rate is a far more accurate barometer of inflation’s impact on asset correlations. We believe the recent heightened correlation, when viewed through a longer lens later down the road, will seem less significant in its broader context than short-term analyses may imply.

Even if current correlations aren’t in line with historical figures, bonds can still fulfill their role as a portfolio diversifier, and their inclusion in target-date strategies remains justified.

Bond diversification provides built-in ballast

Maintaining a highly diversified bond portfolio can also help mitigate the impact of inflation and rising rates. This is particularly valuable for older TDF investors approaching or in retirement, for whom bonds often represent a significant part of their asset allocations.

At Vanguard, we purposefully design our Target Retirement Fund bond allocations to be highly diversified, including short- to intermediate-duration bonds that are less affected by rate increases, as well as a broad range of sectors, issuers, and international exposure to more than 35 countries.

To further extend the benefits of diversification, Vanguard also adds exposure to short-term Treasury Inflation-Protected Securities (TIPS), providing another layer of insulation against inflation for older investors approaching and in retirement. You can read more about the many ways Vanguard hedges inflation risk for our Target Retirement investors in our article "Concerned About Rising Inflation?"


Despite challenging market conditions causing concern among many plan sponsors and their participants, we believe now is not the time to shift away from fixed income. The impact of rising rates, while uncomfortable in the near term, could ultimately benefit long-term investors.

Predicting how rate changes could impact future bond returns is fairly straightforward; predicting when rates will change in the future is notoriously difficult. Rather than trying to mitigate the potential impact of short-term market movements, our Target Retirement Funds focus on positioning participants to achieve their investment goals across all market environments.

Whether the market is careening lower or rocketing higher, Vanguard maintains its steadfast target-date strategy, relying on time-tested principles that have served our investors well over many years.

1 Duration refers to the weighted average duration of the individual bonds in the investor’s bond portfolio and is a measure of interest rate sensitivity; duration is not equivalent to the investor’s time horizon or the bonds’ time to maturity.

2 Source: Bloomberg. See Figure 1 for additional context.

3 Source Vanguard. Renzi-Ricci, Giulio, and Lucas Baynes, "Hedging Equity Downside Risk With Bonds in the Low-Yield Environment," August 2021.

4 Shen and Weisberger, “US Stock-Bond Correlation: What Are the Macroeconomic Drivers?”, May 2021.


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