People buy target-date mutual funds to avoid unpleasant surprises.
But older investors in these retirement-oriented funds -- and more broadly, any investors who hold fixed-income securities -- could be in for an unexpected jolt if interest rates rise sharply, as they threatened to do in the first quarter.
Interest rates fell to generational lows in recent years as the economy struggled in the aftermath of the global financial crisis. But with the economy gathering steam lately, many investment professionals say rates are much likelier to rise than fall.
Rates surged late in the first quarter, with the yield on the 10-year Treasury bond jumping to 2.38 percent on March 19 from 1.94 percent on March 6. They've since settled back around 2 percent, but nonetheless were up from 1.88 percent at the start of the year.
Higher rates could mean losses in fixed-income holdings because rising rates reduce the value of previously issued bonds paying lower yields.
Older savers, whose target funds tend to have larger fixed-income holdings, have greater exposure to this risk.
"If there is a significant spike (in rates), the fixed-income portion of some of these funds is going to be hurt," said Josh Charlson, a target-date analyst at Morningstar Inc. "Managers are aware of it and there's been a lot of thinking about how to protect retirees from unexpected shocks."
Target funds invest in a mixture of stocks and bonds, and are pegged to shareholders' expected retirement date, such as 2030 or 2040. As that date approaches, the portfolio gradually becomes more conservative, with funds typically selling stocks and buying bonds.
Target funds are popular in 401(k) retirement plans because of their ease of use. They automatically shift money between investments, freeing investors of the responsibility for doing so.
Although none have made major changes, some fund companies have tweaked their target funds a bit to guard against rising rates. Many have lightened their holdings of Treasury securities and boosted high-yield bonds or other investments that are considered less sensitive to rising rates.
T. Rowe Price, for example, has lightened its "core" bond allocation but has increased its helping of high-yield and emerging-market bonds, as well as stocks.
"In every aspect that we are able to within the portfolio, we have positioned as best we can for the likelihood of an eventual rising interest-rate environment," said Jerome Clark, manager of the T. Rowe Price retirement funds.
Similarly, American Century has increased its holdings of corporate bonds, including high-yield and commercial mortgage-backed securities.
Many experts say any increase in rates should come slowly, limiting any possible damage.