Active Fixed Income Perspectives: 1st quarter 2019

April 29, 2019

 

Key highlights

Interest rates: We expect the Fed to dial back on rate hikes in 2019 to just one. The yield curve will continue to flatten, with long-term yields capped by lower inflation and slower growth.
Credit: We are marginally more constructive on emerging markets bonds. High-quality, securitized sectors will remain core tenets of our defensive credit posture.
Municipals: We expect continued strong demand across shorter maturities and long municipal yields to hover close to long Treasury yields. A focus on premium callable bonds, which provide more stability and better yield per unit of duration, remains a core strategy.
 

The first quarter of 2019 had a sharp reversal from the end of 2018 in both market sentiment and performance. This was guided by successive dovish signals from the Federal Reserve, including March's comments, which took the bond market by surprise and sent yields considerably lower.

The strong, and contrasting, reactions to the Fed's comments over the prior two quarters highlight the continued disconnect between Fed communication and market interpretation. As such, we begin the second quarter with the Treasury yield curve taking a somewhat unusual "S" shape.

U.S. Treasury and municipal yield curves

U.S. Treasury and municipal yield curves

Sources: Vanguard calculations, using Bloomberg data, U.S. Treasury

Economic outlook and rates

We continue to expect a deceleration in economic growth during 2019 but do not view a U.S. recession as imminent. Economic data in China have weakened, but we expect stabilization toward midyear, prompted by supportive fiscal policy. This is likely to have positive spillover effects on European growth, which has been underwhelming. Trade tensions remain a wild card, with downside risk to the global economy, but progress toward a resolution will support growth.

The U.S. Treasury yield curve inversion warrants discussion. While historically a reliable predictor of tougher economic times, we are not giving full credence just yet to the predictive power of this recent inversion. The reason being the federal funds rate is close to neutral, rather than restrictive. Previous inversions have coincided with tighter monetary policy. Additionally, past inversions that led to recessions have tended to start at the long end and migrate to the short end. This time, the reverse is happening, possibly signaling that the market may expect the Fed to ease relatively soon. We respect this signal, but we need to see persistence in the yield curve’s inverted state to determine its significance. Given the extreme flatness of the yield curve, our preferred strategy is to position for curve steepening, since we believe it could transpire across a number of scenarios.

U.S. agency/U.S. mortgage-backed securities

We entered the year overweight to agency mortgage-backed securities (MBS), given their attractive valuations. This view proved beneficial as the quarter's strong rally pulled MBS spreads tighter. Going forward, we see the picture for MBS as more challenged, and we have reduced our overweight. Interest rates on mortgage loans have fallen in tandem with the recent decline in Treasury yields, resulting in a higher likelihood that mortgage holders will refinance. This increased convexity risk has, and will continue to, hurt valuations. In addition, mortgage supply will pick up following spring home-buying season and as the Fed continues to unwind its MBS positions. We have moved to a neutral posture on MBS, with a focus on securities that offer better prepayment protection.

Inflation/TIPS

Break-even inflation (BEI) spreads widened during the first few months of the year largely because of a strong rebound in oil prices and a calming of global risks, but levels are still below the range that persisted for most of 2018. Oil's retracement of more than 30% in the first quarter brings the price of West Texas Intermediate crude oil within the expected range we highlighted late last year. Drivers of inflation overall have been mixed and below the Fed's 2% target, but the Fed is indicating more willingness to let inflation run above this level. The market is in a show-me mode, however, and we think it will take several strong inflation readings with no Fed reaction for investors to raise their longer-term inflation expectations. By the end of the year, we see core inflation muted, but ending close to 2%. Near term, we are taking advantage of opportunities in a seasonal 1-year BEI carry trade and a long position in 30-year BEI because we see it as underpriced.

Implications for Vanguard funds:

  • Maintain a close-to-neutral duration overall, but positioned for a steeper curve.
  • Remain overweight to 30-year BEI and are tactically long in shorter-maturity TIPS.
  • Shift to a neutral MBS position, based on less attractive valuations and increased convexity risk.

Credit markets

First-quarter performance across fixed income credit reflects a sharp reversal from the "risk off" tone that pushed spreads significantly wider during the fourth quarter of 2018. This rally was driven by the Fed's pivot to a more dovish posture—pausing interest rate hikes and slowing its balance sheet runoff.

U.S. investment-grade and high-yield corporate valuations richened in the quarter, reaching the 25th percentile of historical spread levels. Given our outlook, today's valuations leave less scope for further price appreciation. A U.S. economy that avoids a recession would provide only moderate upside from today's levels, while the onset of a recession would prompt large underperformance—once again, credit offers an asymmetrical risk/return profile.

Retracement in credit spreads

Retracement in credit spreads

Source: Bloomberg Barclays, as of March 31, 2019.

That being said, we are comfortable maintaining overall credit-risk exposure near the lower end of our range and still see tactical opportunities in parts of sectors where valuations haven't completely adjusted to the recent rally. Subsector and issuer selection, along with up versus down in quality, are levers we expect to pull to add value in this environment.

Investment-grade1 corporates

A January rally in credit spreads, combined with a March decline in Treasury yields, pushed first-quarter returns in the sector above 5%. Industrial issuers outperformed financials and utilities, driven by a strong rebound in energy prices that bolstered energy-related subsectors. A more accommodative Fed tone, an increase in demand from non-U.S. investors, lower net supply, and a relatively stable fundamental backdrop have helped further support credit sentiment. We used this opportunity to reduce or exit positions in highly levered or less liquid issuers that we view as being vulnerable in a decelerating U.S. economy, and to lean into higher-quality U.S. and non-U.S. banks.

Interestingly, we've seen market participants show more patience with corporate issuers relative to last year. Downward revisions to company guidance and even rating downgrades have been met with less negative price impact. We are encouraged by the more "bondholder friendly" steps several firms have taken to decrease leverage, but we acknowledge that this environment warrants a more selective approach. We view valuations as fair and fundamentals as somewhat stretched, but an overall accommodative environment in the near term presents better relative value in BBBs versus As, with opportunities for security selection across the sector.

Structured finance

Consistent with their lower beta relative to other credit sectors, asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) followed the quarter's pattern of spread compression, but to a lesser degree. We continue to see a supportive case for ABS from a strong U.S. consumer and for CMBS from stable property valuations and a favorable supply-demand dynamic. With respect to fundamentals, we do not see any major areas of concern. Pockets of delinquencies or borrower defaults will likely be contained, and bondholders should benefit from overcollateralization and our focus on diversification within our securitized exposure. Our positioning reflects a defensive bias—moving up in credit quality through higher-rated auto securities and adding back exposure to higher-quality subsectors, such as credit cards.

Emerging markets

Emerging markets (EM) benefited considerably from a pause in U.S. interest rate hikes. This, alongside strong investor demand, supportive country fundamentals, and a lower-than-expected early-year supply, boosted performance across both investment-grade and high-yield EM issuers. After an especially strong start to the year, the rally in EM debt moderated in March. Our portfolios benefited from an overweight to the sector during the quarter, and we still see opportunities going forward, but any further spread tightening will likely require a catalyst and be led by lower-quality EM issuers.

As anticipated, the technical backdrop is becoming more challenging as new supply has picked up meaningfully and credit spreads are at richer levels. We expect a reduction in demand from profit taking and have moved into a neutral position to the sector overall. This is expressed through a tactical overweight in select lower-quality issuers, such as Argentina and Ukraine, offset by overweight positions in high-quality Middle East issuers, such as Qatar. Notably, we are underweighting Turkey amid significant volatility.

High-yield corporates

The recovery in high-yield corporates throughout the first quarter was swift, marking the strongest start to a calendar year on record. Although high-yield bonds recovered most of their losses from the fourth quarter, current spreads of 390 basis points (bps) remain 90 bps wider than the postcrisis tights of October 2018.

The first-quarter rally has been atypical in that lower-quality high-yield credits have not outperformed. BB-rated bonds have recovered more than twice what they lost during the end of 2018, while CCC-rated bonds have recovered only about 75% of their fourth-quarter losses. We see a few key reasons for this. First, CCCs outperformed meaningfully in the summer of 2018. Second, BBs have benefited from their longer duration and higher liquidity. Third, we believe the downturn in global economic data has caused investors to avoid going too far down in quality. Buying BBs is the easier and more liquid method to benefit from a beta-driven market recovery without adding a large amount of default risk late in the economic cycle. While the down-in-quality underperformance is notable, we don’t view this as an indicator of an imminent recession.

Although the first quarter saw robust issuance, the high-yield technical picture remains strong, supported by meaningful inflows to high-yield bonds ($10.6 billion), which came largely from bank loans ($10.1 billion in outflows). While expected defaults remain low, high-yield valuations have recovered and now leave only moderate upside. We continue to favor the lower relative risk of BBs despite their recent outperformance and are focused on adding value primarily through bottom-up credit selection.

Implications for Vanguard funds:

  • Slightly overweight credit exposure overall but hovering near the lower end of our range, based on a positive near-term view and a watchful longer-term outlook.
  • Overweight select BBB and BB-rated corporate bonds, avoiding vulnerable names with high leverage and weaker growth prospects.
  • Move toward an overall neutral position to EM ahead of a more challenging technical backdrop, but capitalize on tactical opportunities along the credit-quality spectrum.

Municipal bonds

Municipal yields

Municipal bonds experienced exceptionally strong demand during the first quarter of 2019. As investors filed taxes for the first time under the new tax code, the value of municipal bonds' tax exemption took center stage. Additionally, we suspect investors continued to find munis attractive for their higher quality, lower volatility, and global insulation relative to riskier assets. Following strong demand, as well as the Fed's dovish March guidance, muni yields fell across the curve. Short- and intermediate-term yields continued to benefit from strong investor preference as well as demand from SMAs, which generally prefer bonds inside of 10 years. Long-term yields also moved considerably lower as investors shifted their appetite for longer-maturity bonds following a decrease in extension risk. Muni-to-Treasury ratios maintained their rich levels versus recent history but still provide an adequate tax benefit to investors in higher tax brackets. We believe this richness is more pronounced in shorter maturities, and consequently we are finding better relative value further out on the curve. As a result, our funds are positioned with a slight lean into intermediate- and longer-maturity bonds, with respect to each fund’s investment universe. Additionally, we see few near-term catalysts to reverse the strong technical environment and drive rates higher. To capitalize on this, we have positioned funds with a slight long-duration bias.

Yield difference by quality

 9/30/201812/31/20183/31/2019
AAA2.62%2.41%2.04%
AA+9 bps+11 bps+13 bps
A+42 bps+49 bps+47 bps
BBB +100 bps +118 bps +112 bps
High yield +226 bps +262 bps +264 bps

Source: Bloomberg Barclays, using yield to worst.

Implications for Vanguard funds:

  • Slight long-duration tilt in intermediate- and long-term funds. Lean into longer-maturity bonds for better relative value, respective to each fund's investment opportunity set.
  • Continue to emphasize premium callable bonds, which provide more stability and better yield per unit of duration.

Municipal credit

Spreads in lower-rated bonds drifted tighter as the quarter ended but remain wider than their October 2018 lows. Carry drove lower-quality bonds to marginally outperform higher-quality bonds, and we view this trend as likely to persist over the coming months. Our funds remain positioned to capture modest carry, but we continue to hold a guarded view on the risk/return symmetry that lower-rated bonds offer at this point in the credit cycle. We are emphasizing issuer selection and bond structure to drive excess returns in this environment.

In keeping with our view of gradually de-risking portfolios, the team modestly reduced exposure in sectors that we believe are most sensitive to economic deceleration, such as tobacco and continuing-care retirement facilities. Additionally, the team directed the first quarter’s cash inflows toward highly rated investment-grade issuers to gradually upgrade the complexion of our portfolios.

During the quarter, states and municipalities began discussing budgets for the coming fiscal year. For larger state issuers in the funds, such as California and Illinois, we view respective governor proposals as credit stable to credit positive. For instance, we like California Governor Gavin Newsom's focus on one-time spending items rather than recurring expenditures, as well as the state's commitment to maintaining a fully funded rainy-day fund. Illinois appears likely to vote on an income tax change in 2020, a move that signals the state’s willingness to raise revenues to alleviate its financial challenges.

Spotlight on Puerto Rico: After a multiple-year proceeding, Puerto Rico's sales tax bonds (commonly known as COFINA bonds) completed restructuring and began trading in February. COFINA represented roughly 25% of Puerto Rico's outstanding defaulted debt. We remain cautious on Puerto Rico's long-term economic recovery, but we view the newly restructured, shorter-maturity COFINA bonds as having attractive yields and ample coverage. The team purchased small allocations of short-term COFINAs across our national funds (current exposures between 5 and 10 bps). State funds continue to hold zero exposure, while Vanguard High-Yield Tax-Exempt Fund holds approximately 30 bps.

Implications for Vanguard funds:

  • Supplement modest credit carry by emphasizing bond-structure evaluation and issuer recommendations from our credit team.
  • Opportunistically tilt away from more cyclically sensitive municipal sectors in favor of sectors we believe are better positioned to withstand economic deceleration, such as transportation and utilities.

Vanguard active bond funds

  Investor Shares Admiral™ Shares
Vanguard FundTicker
symbol
Expense
ratio2
Ticker
symbol
Expense
ratio2
Vanguard active taxable bond funds
Treasury/agency
GNMA3 VFIIX 0.21% VFIJX 0.11%
Inflation-Protected Securities VIPSX 0.20 VAIPX 0.10
Intermediate-Term Treasury VFITX 0.20 VFIUX 0.10
Long-Term Treasury VUSTX 0.20 VUSUX 0.10
Short-Term Federal VSGBX 0.20 VSGDX 0.10
Short-Term Treasury VFISX 0.20 VFIRX 0.10
Investment-grade corporate
Core Bond VCORX 0.25% VCOBX 0.13%
Intermediate-Term Investment-Grade VFICX 0.20 VFIDX 0.10
Long-Term Investment-Grade3 VWESX 0.22 VWETX 0.12
Short-Term Investment-Grade VFSTX 0.20 VFSUX 0.10
Ultra-Short-Term Bond VUBFX 0.20 VUSFX 0.10
Below-investment-grade
High-Yield Corporate3 VWEHX 0.23% VWEAX 0.13%
Global/international
Emerging Markets Bond VEMBX 0.60% VEGBX 0.45%
Global Credit Bond VGCIX 0.35 VGCAX 0.25
Vanguard active municipal bond funds
National municipal
Short-Term Tax-Exempt VWSTX 0.17% VWSUX 0.09%
Limited-Term Tax-Exempt VMLTX 0.17 VMLUX 0.09
Intermediate-Term Tax-Exempt VWITX 0.17 VWIUX 0.09
Long-Term Tax-Exempt VWLTX 0.17 VWLUX 0.09
High-Yield Tax-Exempt VWAHX 0.17 VWALX 0.09
State municipal
California Intermediate-Term Tax-Exempt VCAIX 0.17% VCADX 0.09%
California Long-Term Tax-Exempt VCITX 0.17 VCLAX 0.09
Massachusetts Tax-Exempt4 VMATX 0.13
New Jersey Long-Term Tax-Exempt VNJTX 0.17 VNJUX 0.09
New York Long-Term Tax-Exempt VNYTX 0.17 VNYUX 0.09
Ohio Long-Term Tax-Exempt4 VOHIX 0.13
Pennsylvania Long-Term Tax-Exempt VPAIX 0.17 VPALX 0.09

1 Investment-grade fixed income securities are those rated the equivalent of Baa3 and above by Moody's or another independent rating agency.

2 As reported in each fund's prospectus. A fund’s current expense ratio may be higher or lower than the figure shown.

3 Investment advisor: Wellington Management Company LLP.

4 There is no minimum investment required for advised clients.

Active Fixed Income research team

Chris Alwine
Christopher Alwine, CFA
Global Head of Credit
Dan LarkinDan Larkin
Senior Product Manager–Taxable Bonds
Paul MalloyPaul Malloy, CFA
Head of U.S. Municipals
Torre Swanson
Torre Swanson, CFA
Product Manager–Municipal Bonds

 

Active Fixed Income leadership team*

Chris AlwineChris Alwine, CFA
Principal and Global Head of Credit
28 years of experience
Joe DavisJoe Davis, Ph.D.
Global Chief Economist
16 years of experience
Manish NagarManish Nagar
Global Head of Risk Management Group
18 years of experience
John HollyerJohn Hollyer, CFA
Principal and Global Head of Fixed Income Group
29 years of experience
Paul MalloyPaul Malloy, CFA
Head of U.S. Municipals
13 years of experience
Anne MathiasAnne Mathias, CFA
Global Rates and FX Strategist
22 years of experience
Ron ReardonRon Reardon
Global Head of Rates
29 years of experience
    

 

AFI experience

* Includes funds advised by Wellington Management Company LLP.
Note: Data as of March 31, 2018.

Notes:

  • Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal.
  • Bonds of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
  • High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.
  • 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 bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
  • Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
  • Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • CFA® is a registered trademark owned by CFA Institute.

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