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I recently wrote an article titled "Why Long-term Government Bonds Are The 'Dumbest Investment" that made the case that with interest rates at these levels the risks simply don't outweigh the benefits of owning them. As these videos highlight, I'm not alone.

Video #1

Video #2

The reason so many high profile investors are coming out against long-term bonds is simple mathematics. Technically interest rates can fall to 0%, but practically they should only fall to the rate of inflation plus a premium, at least according to the text books. The current interest rate on the 10% treasury bond is slightly below the rate of inflation, defying the text books, but likely representing a level close to the bottom in bond rates. This graphic shows the current valuation of a $10,000 treasury bond with a yield of 2% (assuming annual payment of interest at the end of the year).

(click to enlarge)Bond

Currently a $10,000 face value bond yielding 2% pays $200/yr in interest and with the interest rates at 2%, its present value is $10,000. The theoretical maximum value of that bond is its value when interest rates drop to 0%. If that were to happen, the bond's present value would be $12,000, a 20% gain. 20% represents the maximum gain an investor in this bond could hope to gain from a decline in interest rates. The likelihood of that happening however is extremely small, especially if inflation continues to strengthen. According to the Federal Reserve of St. Louis, the interest rate on the 10 yr treasury has never been as low as 0%, in fact it has never closed lower than 1.4%.

(click to enlarge)Fred

The following chart demonstrates how the 10 yr treasury rates (red line) rarely reaches levels below the annual "core" rate of inflation (blue line). When it does, it has always been a relatively short-term phenomenon. Current levels have the CPI at basically the same level as the 10 yr interest rate.

(click to enlarge)Core 10 yr

If we accept the thesis that the 10 yr treasury rates are usually above the annual core rate of inflation, and that currently the 10 yr treasury rate is essentially trading at the rate of inflation and that inflation has been in an uptrend since late 2010 early 2011 and is likely to continue higher, then we can feel pretty comfortable that we are likely near a peak in bonds, at least the 10 yr treasury bonds. If that is in fact the case, then the above table highlights what an investor can expect if interest rates increase. If interest rates increase to 5%, the value of the 10 yr treasury will drop by 23%. If the Fed loses control of inflation and rates increase to 10%, the bond will drop by 49%, or will basically be cut in half.

While the likelihood of the 10 yr interest rates rapidly increasing to 10% is unlikely, reaching 5% is highly probable, if not likely. 5% is below the long term average of around 6.15%. If that happens the 2% 10 yr treasury bond being issued today will drop by 23%.

My last article highlighted bond ETFs and the risks they face - this article is to highlight that bond portfolios are not the only ones at risk, balanced and target retirement portfolios are also at risk. Many people may not associate interest rate risk with their balanced and target retirement portfolios, but interest rate risk is applicable to them as well. Here is a list of target retirement and balanced funds as well as their fixed income exposure:

Source:

Cambria Global Tactical ETF (NYSEARCA:GTAA) has 27% bonds, 22% domestic fixed income, 5% foreign fixed income.

ISHARES S&P Aggressive Allocation Fund (NYSEARCA:AOA) 18.89% domestic fixed income

ISHARES S&P Conservative Allocation Fund (NYSEARCA:AOK) 70.98% domestic fixed income

ISHARES S&P Growth Allocation Fund (NYSEARCA:AOR) 40.25% domestic fixed income

ISHARES S&P Moderate Allocation Fund (NYSEARCA:AOM) 57.24% domestic fixed income

ISHARES S&P Target Date 2010 Index Fund (NYSEARCA:TZD) 57.44% domestic fixed income

ISHARES S&P Target Date 2015 Index Fund (NYSEARCA:TZE) 47.73% domestic fixed income

ISHARES S&P Target Date 2020 Index Fund (NYSEARCA:TZG) 38.75% domestic fixed income

ISHARES S&P Target Date 2025 Index Fund (NYSEARCA:TZI) 31.48% domestic fixed income

ISHARES S&P Target Date 2030 Index Fund (NYSEARCA:TZL) 24.53% domestic fixed income

ISHARES S&P Target Date 2035 Index Fund (NYSEARCA:TZO) 19.66% domestic fixed income

ISHARES S&P Target Date 2040 Index Fund (NYSEARCA:TZV) 15.59% domestic fixed income

ISHARES S&P Target Date 2045 Index Fund (NYSEARCA:TZW) 12.29% domestic fixed income

ISHARES S&P Target Date 2050 Index Fund (NYSEARCA:TZY) 9.70% domestic fixed income

ISHARES S&P Target Date Retirement Income Index Fund (NYSEARCA:TGR) 68.28% domestic fixed income

db-X Independence 2010 ETF (NYSEARCA:TDD) 80.33% fixed income

db-X Independence 2020 ETF (NYSEARCA:TDH) 43.07% fixed income

db-X Independence 2030 ETF (NYSEARCA:TDN) 19.22% fixed income

db-X Independence 2040 ETF (NYSEARCA:TDV) 5.4% fixed income

db-X Independence In-Target ETF (NYSEARCA:TDX) 66% fixed income

Unfortunately I was unable to find the duration of the fixed income holdings of the above portfolios, but according to the TDV fact sheet, 98% of its fixed income holdings have a maturity of "10 years +." As demonstrated from the list above, some of the balanced and target retirement portfolios have fixed income exposure greater than 70 and even 80%. Investors in these securities should review their fixed income holdings to ensure that the interest rate risk is appropriate for their return expectations and risk tolerances.

In conclusion, not only are bond portfolios subject to interest rate risk, balanced and target retirement portfolios are as well. Many investors simply buy a target retirement fund and "fugetaboutit." Investors in these securities should understand the fixed income exposure and associated risks. Target retirement funds may not be the best investment for investors planning for retirement if we enter an extended period of rising interest rates. My next article on this topic will explore what alternatives exist to holding traditional government bonds, and portfolio strategies to build a target retirement portfolio better suited for the rising rate environment we are likely to face in the future.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Source: Bond Holdings Are Likely To Be A Drag On Target Retirement And Balanced Portfolios