Active Fixed Income Perspectives: 2nd Quarter 2019

July 22, 2019

 

Key highlights

Interest rates: Preemptive interest rate cuts should place a ceiling on yield levels and resteepen the Treasury curve. We remain committed to steepener trades across funds.
Credit: Reduced overall credit risk given full valuations and market uncertainty. We favor sectors and industries are less exposed late-cycle risks and trade uncertainty.
Municipals: Munis should benefit from a strong period. We maintain slight overweight to A and BBB rated muni bonds and are treading cautiously in high-yield munis.
 

The second quarter of 2019 saw risk-on market sentiment oscillate as attention was fixed on trade escalation, softening economic data, and expectations for supportive monetary policy action from the Federal Reserve. The uncertainty on multiple fronts pushed investors toward fixed income assets, consequently driving down yields across the U.S. Treasury yield curve and across many segments of the bond market. Once again, we face a familiar environment of low, less attractive absolute yields and a wide distribution of paths going forward. While the uncertainty in the economic and global geopolitical environment has the potential to limit growth, the trillion-dollar question remains, "Will it persist long enough to make sentiment become reality?"

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

Ongoing trade uncertainty with multiple key trading partners, along with persistently declining U.S. housing investment, echo our expectations for slowing U.S. economic growth. We downgraded our expectation for U.S. real GDP growth from 2.0% to 1.7% and slightly increased the likelihood of a recession in the next 12–18 months. But our base case remains that economic growth is "down but not out," with a nonrestrictive monetary policy and the lack of household overleverage being key stabilizing factors.

With low unemployment and inflation expectations along with continued yield curve inversion, we expect the Fed to continue their dovish stance. Central banks in the developed world may entertain accommodative stances, while China could take further stimulus measures to sustain growth. This makes for a challenging investment environment for government bonds. Given this outlook, we think the Fed will be more preemptive with rate cuts than in the past. When those happen, the inverted yield curve will likely steepen. We are committed to curve-steepening trades across our active funds as a longer-term strategy. We also favor tactical long-duration positions when valuations seem attractive.

U.S. mortgage-backed securities

The performance of mortgage-backed securities (MBS) lagged other sectors this year as supply increased, demand weakened, and bond prices reflected the negative effects of falling interest rates. With the rally we've seen, we might have expected more turmoil in MBS because lower yields prompt increases in mortgage prepayments, reducing the duration of mortgage portfolios. This drives holders of MBS to seek ways to cover that duration reduction, increasing demand for Treasuries and driving yields down further. Refinancing rates, however, have not dropped very much, since lenders seem to feel that the current rally may be short-lived. Notably, a modest decline in mortgage rates to near 3.75% should more than double the number of borrowers able to refinance.

Given that backdrop, we remain neutral on MBS and prefer targeted exposure to securities that offer protection against prepayment risk. We will look for valuations to cheapen further before adding any additional exposure to the sector.

Inflation/TIPS

The early May breakdown of both the U.S.–China trade talks and the Brexit negotiations increased concerns about global growth, resulting in a flight-to-quality to Treasuries. In this environment, real yields rallied less and inflation expectations fell. Currently the TIPS (Treasury Inflation-Protected Securities) market implies a 1.2% inflation rate for the headline Consumer Price Index for the next two years. In our opinion this is too low given the possible backdrop of a more accommodative monetary policy and the potential inflationary effects of trade restrictions. We are keeping a close eye on economic conditions and expressing our view through a 1-year breakeven inflation (BEI) spread exposure, because we see it as underpriced.

Implications for Vanguard funds:

  • Strategically holding steepener positions, with tactical, long-duration positions when valuations are compelling.
  • Maintaining an overweight allocation to 1-year BEI spreads, expecting positive seasonal effects and a rebound in inflation expectations.
  • Holding a neutral allocation to MBS, with a focus on securities with superior prepayment protection characteristics.

Credit markets

Following a strong start to the year, the performance rally across fixed income credit moderated during the second quarter as spreads tightened at a slower pace. Total returns across credit sectors also benefited from another quarter of sharply declining Treasury yields.

We expected the Fed's more dovish posture to translate to a supportive environment for credit until market sentiment reached an inflection point brought on by either weakening economic data or increased uncertainty around trade conditions. Both factors contributed to periods of capitulation of the market’s “risk-on” mentality of late, but globally, investor demand for yield remains strong. With today’s valuations considerably less attractive, we expect a more challenging environment for credit in the second half of the year, and we are preparing our portfolios accordingly. We reduced overall credit risk in mid-April and continue to favor sectors and industries with less exposure to late-cycle risks and trade uncertainty.

Monthly spread change by sector (bps)

Monthly spread change by sector (bps)

Source: Bloomberg (Bloomberg Barclays Indices, J.P. Morgan EMBI Global Diversified Index).

Investment-grade corporates1

A mix of supportive monetary policy, relatively stable economic conditions, and solid corporate earnings pushed returns on high-quality corporate bonds to near 10% for the year. In April, credit spreads touched their lowest levels of 2019 before experiencing a May sell-off driven by weaker-than-expected global manufacturing data, trade tensions, and a resurgence of recessionary fears. Among the hardest-hit sectors, unsurprisingly, were technology and the automotive industry since they were the most affected by trade restrictions. Sentiment reversed course again in June as credit spreads retraced their previous lows, with the market anticipating multiple interest rate cuts by the Fed and improvements on the trade front.

We view valuations in the sector as expensive and are paying close attention to a weakening of corporate fundamentals. Bank balance sheets remain a bright spot, but the focus on deleveraging exhibited by industrial issuers early in 2019 has slowed. Corporate issuance was down 10% relative to the first half of 2018, but we anticipate that the impact of lower funding costs and tempered expectations for organic growth could translate into a resurgence of merger and acquisition activity.

Our team continues to upgrade our portfolios with respect to credit quality, and we favor sectors that are more insulated from trade-related headlines, such as aerospace and defense, health care, pharmaceuticals, and communications. We prefer to stay at the low end of the risk range as we await greater clarity on the impact of recent trade developments on the global economy and corporate fundamentals.

Structured finance

Higher-quality structured product sectors remain a core allocation across our portfolios because of their defensive nature, particularly as we reduce overall credit risk.

Credit card portfolio metrics are often cited as a gauge of consumer financial health since charge-off rates are closely correlated with jobless claims and unemployment. Overall rates of delinquency and defaults have risen from very low levels in recent years, but still are low when compared with longer-term historical ranges. Despite robust competition among the major U.S. card lenders, decisions to extend credit appear rational, with borrowers’ payment rates trending near 20-year highs. While we see valuations as too rich in asset-backed credit card securities, our conviction in the health of the U.S. consumer is expressed in an overweight to auto-related securities and higher-quality private student loans.

In the second quarter, commercial real estate fundamentals continued to improve at a steady pace as the delinquency rate on overall commercial mortgage-backed securities (CMBS) for both pre- and postcrisis vintages declined to new lows. We remain constructive on the sector as property values continue to reach new highs, providing a cushion to prior vintage securities and ultimately reducing the likelihood that individual loans will turn sour.

Emerging markets

Emerging markets (EM) debt posted another strong quarter even as investors' appetite for riskier assets moderated. Credit spreads were held in check as flows remained positive despite the macro-related uncertainties of trade and global growth. We have moved to a more defensive position given increased levels of volatility and our view that emerging markets' credit risk is skewed to the downside. If Treasury yields begin to stabilize, the next widening of credit spreads could force investors out of the asset class because of negative total returns.

While broader valuations across the sector are rich, we favor higher-quality countries and selective positioning in more troubled ones like Argentina and Turkey, given that much of the downside has already been priced in. While risky assets may benefit in the near term because of a reprieve in U.S./China trade relations, credit spreads leave little upside from current compressed levels. In this environment, we think EM local rates offer a better risk/reward in place of owning riskier U.S. dollar-denominated credits.

High-yield corporates

With six-month returns approaching 10% and credit spreads only 75 basis points away from October 2018 post-crisis tights, it's easy to conclude that investors are aggressively taking on risk. When we look under the hood, however, we see an increasingly cautious investor base concerned about fundamentals.

High-yield corporate bonds experienced $18 billion of inflows in the first half of 2019, the largest into the sector since 2012.2 Spreads widened meaningfully during the May sell-off, but recovered in June as demand outstripped supply. Unlike a normal risk-seeking rally, the buying was almost entirely focused on the most liquid and highest-quality part of the high-yield market. In terms of performance, BB rated securities continued to outperform both B rated and CCC rated securities.

We continue to prefer higher-quality credits, but do see more limited upside in our preferred exposure. We are maintaining an underweight to the sector more broadly, but favor more consumer-focused industries such as leisure, gaming, and restaurants as we look for companies with strong, free, cash flow and healthy balance sheets.

Implications for Vanguard funds:

  • Reduced overall credit exposure in mid-April based on tighter valuations and our expectations for growth to further decelerate.
  • Favor allocations to structured products and higher-quality corporate bonds, avoiding vulnerable names with high leverage and weaker growth prospects.
  • Maintain an overall neutral position in emerging markets and high-yield corporates with a focus on idiosyncratic opportunities, since broader price appreciation remains limited.

Municipal bonds

Municipal yields

Investors continued to flock to municipal bonds during the second quarter. While the intensity of flows subsided from earlier in the year, the record-setting $50 billion in inflows year-to-date2 highlighted the value being placed on municipals as both a tax haven and a risk haven. Supply remained muted post tax reform, but there was a modest uptick over the quarter, which was easily absorbed by investors. We continue to estimate that this year will see a below-average level of municipal issuance.

Municipal yields continued to slide amid strong demand and expectations for accommodative monetary policy. Longer-term yields had the steepest declines, as muni investors turned to longer-maturity bonds to maintain yield. This shift richened long-term muni-to-Treasury ratios to multiyear lows, while intermediate- and short-term ratios cheapened as Treasury yields sank at a faster pace. Consequently, shorter-term munis were more attractive when looking through a relative value lens. We directed inflows toward shorter-dated bonds to take advantage of these better valuations. However, we maintain a preference for bonds in the 12- to 20-year maturity range because this part of the curve provides an attractive yield per unit of duration risk.

After benefitting from a longer-duration lean during the first quarter, we returned our funds to a neutral posture during the second quarter. The competing forces of rich valuations, macro uncertainties, and exceptionally strong technicals make a close-to-home duration stance prudent in our view, although our funds may tilt to a longer duration to take advantage of a stronger-than-average summer technical period (with negative net supply).

Spotlight on high-yield munis

The average high-yield municipal bond yielded over 2% more than the Bloomberg Barclays Municipal Bond Index for the second quarter.3 This is an enticing pickup for investors looking at multiyear low interest rates. Accordingly, high-yield muni funds attracted $10 billion in inflows year-to-date, the most in more than 30 years.2 While top-line yields may appear attractive, we caution investors to be wary when large amounts of capital are chasing the same asset class. Select opportunities in the high-yield muni market are attractive, but we view overall valuations as disonnected from the underlying fundamentals and the increased risk of the asset segment. We certainly aren’t sounding the alarm bell, but we urge you to fully evaluate the wider distribution of potential outcomes for high-yield munis when making your investment allocation decisions.

Municipal credit

The second quarter highlighted investors' acute interest in maintaining yield. As such, lower-rated bonds saw spreads compress on the back of strong demand. In particular, states with lower credit ratings such as Illinois, Pennsylvania, and Connecticut experienced significant tightening following higher-than-forecast tax windfalls from the Tax Cuts and Jobs Act, as well as general economic growth.

Spread levels (10-year)

Spread levels (10-year)

Source: Bloomberg (Bloomberg Barclays Indices).

We continue to maintain lower-than-normal exposure to muni credit, given stretched valuations in a slowing economic environment, but we're capturing carry from slight overweights to A- and BBB-rated munis. We have also found opportunity to add yield through purchasing high-grade, lower-coupon bonds rather than through adding credit risk exposure. Lower-coupon bonds carry increased interest rate risk, as well as increased liquidity risk given their scarcity, but these risks are unlikely to materialize in a lower-for-longer interest rate environment.

Pockets of the muni market appear rich by historical standards, and the strong fundamentals and insatiable demand help explain these valuations. But it's in compressed environments such as this that our cost advantage really shines. Our low fees allow our investment team to think about risk differently—we can afford to be patient.

Implications for Vanguard funds:

  • Supplement modest carry by emphasizing bond-structure evaluation, particularly for lower-coupon bonds.
  • Maintain a slight overweight to A and BBB rated muni bonds. Focus on selectivity using specific issuer recommendations from our 22-person credit-analyst team.
  • Maintain a duration-neutral target given rich valuations but strong technicals. Funds may tilt slightly long to take advantage of strong summer reinvestment activity.

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

2 Source: Morningstar Inc., as of June 30, 2019.

3 Source: Bloomberg, as of June 30, 2019.

Vanguard active bond funds

  Investor Shares Admiral™ Shares
Vanguard fundTicker
symbol
Expense
ratio4
Ticker
symbol
Expense
ratio4
Vanguard active taxable bond funds
Treasury/agency
GNMA5 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-Grade5 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 Corporate5 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-Exempt6 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-Exempt6 VOHIX 0.13
Pennsylvania Long-Term Tax-Exempt VPAIX 0.17 VPALX 0.09

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

5 Investment advisor: Wellington Management Company LLP.

6 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
Sr. 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 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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