In a world defined by macroeconomic uncertainty and interest rate volatility, conservative investors are facing a dilemma. How do you find safety and attractive, predictable yields without sacrificing liquidity or tax efficiency? The answer may be target date bond funds (TDBFs).
This asset class, a fixed-income variation of the familiar target date funds that use both equities and bonds, is attracting a significant amount of capital, with some issuers even capping funds due to demand.
Interest in TDBFs is a direct response to a changing market environment. As central banks begin to conclude their tightening cycles and interest rates trend downward from their recent peaks, investors are clamouring for fixed-income investments that can lock in attractive yields before they disappear.
Alain Rheaume, senior portfolio manager and team leader at Desjardins Global Asset Management, said the product’s current success hinges on the post-2022 environment. Rheaume explained that the strategy relies on discounted bonds, and while demand for this type of shorter-term fixed income product was lower over the previous decade when interest rates were low, the post-2022 environment became much more favourable.
He also pointed to a “lot of cash in the system, post-Covid,” with investors seeking alternatives that offered an attractive yield compared to GICs on a tax-adjusted basis.
For conservative investors with short-term objectives — like saving for a down payment, a car purchase or a specific tuition goal — the traditional options often fall short.
High-interest savings accounts are one common solution, but their rates can vary and neither they nor GICs are tax efficient. GICs have an additional drawback because they aren’t liquid, locking up the investor’s money until maturity.
Another option is simply a basket of individual bonds. That offers both accessibility and liquidity, but the process of selecting and managing those bonds can be onerous.
TDBFs are tax efficient due to a blended return structure that includes both interest income and capital gains derived from discounted bonds. They’re also diversified, mitigating single-issuer risk.
How the funds are structured
The underlying mechanism of a TDBF is similar to a bond-ladder strategy. Each has a specific maturity date (e.g., 2027, 2030), and the portfolio is constructed using a diversified mix of bonds that mature around that target year.
Rheaume said that investors can also use TDBFs to build their own ladder strategy because they can pick specific maturities. That allows an investor to align a specific financial goal — such as buying a house in two years — with a matching investment by purchasing a 2027 fund, for example. This locks in a yield and a maturity without taking on interest-rate risk associated with longer-duration, traditional ladder strategies.
Investors can buy or sell these funds daily, with a settlement date of trade-date plus one.
Fund allocations can differ based on maturity. For example, shorter-term funds may have more discounted bonds in the corporate universe, while longer-dated funds might have a slightly higher allocation to government bonds.
As a fund evolves and gets closer to its maturity date, the underlying bond maturities are reinvested into the money market. This is necessary because there are fewer discounted bonds and available products to maintain the original bond portfolio at that point. The process preserves capital for the fund’s final payout.
While the funds can invest internationally, the team at Desjardin is cautious. They monitor the U.S. market but, as Rheaume points out, it has often looked too expensive on a spread basis compared to Canada when the assets are currency-hedged back to Canadian dollars. When they do invest abroad, they hedge out the currency risk entirely, preferring to focus on the pure credit spread comparison.
In a market where credit spreads are historically tight, portfolio managers work hard to enhance returns. Rheaume’s team relies on a fundamental analysis performed by a team of credit analysts. The goal is to identify the most promising issuers and sectors while minimizing the risk of credit downgrade or default.
While the team could use derivatives like the Credit Default Swap Index to enhance yield or adjust credit exposure, they have avoided it recently because credit products have been “pretty tight.” They will only deploy such instruments if credit spreads widen to a point where they represent true value.
Duration and rate sensitivity
A key element of these funds is their managed sensitivity to interest rates, which is linked directly to the maturity date. The current interest rate risk is low to moderate overall. The longer the maturity, the more exposure to rate movements.
Portfolio managers have limited ability to play duration within a single fund because of the strict investment policy restricting bond maturities to a specific calendar year. Therefore, the duration decision is made by the investor or advisor when they choose the fund. If they are looking for short duration, they can choose a 2026 or 2027 fund. If they are bullish on rates and expect them to fall, they might take a duration bet by buying a 2030 fund.
TDBFs make sense given the current economic reality. The recent rate cut by the Bank of Canada, while expected, solidifies the narrative of an economy grappling with challenges, including diminished growth expectations and cautious corporate investment.
Rheaume said his central preoccupation is the historically low level of credit spreads, which he believes “do not adequately reflect the growth challenges facing the Canadian economy.” This environment, where everything seems “priced for perfection,” makes his team cautious, driving them to prioritize security selection and prefer low-beta portfolios, focusing on single-A and double-A rated bonds over triple-B.
For conservative investors, this market tension enhances the appeal of TDBFs. They offer professional management and diversification that can lock in today’s relatively attractive yields. Their defined maturity mitigates the duration risk that plagues traditional open-ended bond funds.
Pat Bolland is head of advisor recruitment at Justwealth Advisor Services.