Active Fixed Income Perspectives: 4th quarter 2018

February 4, 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.
 

We start 2019 at a point of great uncertainty. With a recent U.S. government shutdown, a new Democratic-controlled House of Representatives, an embattled president, a new FOMC meeting structure with press conferences each time, no substantive agreements on trade and tariffs, a China slowdown, and Brexit. The list goes on.

Perhaps it is no wonder that equities are skirting a bear market and the 30-year U.S. Treasury yield has tumbled more than 60 basis points. Despite the chaos, we see the U.S. economy as having decent momentum, with a bumpy ride more likely than a recession in the near future.

Economic outlook and rates

In 2019, we expect to see a slowdown in economic growth—led by the United States and China—with periodic "growth scares" as the most likely outcome. In short, economic growth should shift down but not out.

Subsequently, in the United States, our fundamental view has shifted toward a more bearish stance. We now see a higher probability of elevated market volatility and policy uncertainty persisting through the first part of this year, which will likely spill over to fundamentals. As such, we've downgraded our earlier expectation of two Federal Reserve interest rate hikes in 2019 to one.

We believe the markets will regain some of their forward-looking optimism about the economy and risk assets—at least for a short while. We expect a rebound from very pessimistic outlooks to something more moderate, although the likelihood is remote that markets come all the way back to warrant pricing in multiple rate hikes in 2019 and 2020.

U.S. Treasury and municipal yield curves

U.S. Treasury and municipal yield curves

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

Agency/U.S. mortgage-backed securities

We are positive on U.S. mortgage-backed securities (MBS) as valuations have cheapened significantly, reaching the most attractive levels in the past several years. Over the last few months, we've experienced a fairly negative technical environment for MBS, and we see things starting to improve.

Recent slowing in housing data and seasonal trends should lead to a reduction in MBS supply. Although demand has been weak, we expect that to reverse as investors potentially take advantage of more attractive spreads in a high-quality asset class. Despite a recent decline in interest rates, we would need to see significantly lower rates to generate real refinancing concerns.

Inflation/TIPS

The global inflation backdrop softened in the final quarter of 2018 as global economic growth slowed. Concerns that the Fed was "pre-committing" to a restrictive policy stance, despite global slowing, tightened global financial conditions materially and sent U.S. nominal yields sharply lower while TIPS yields lagged. Falling energy prices appear to have stabilized, and our energy team has longer-term expectations for a rebound to a $60–$65 West Texas Intermediate price range.

Looking ahead, the domestic backdrop for inflation appears favorable from a cyclical perspective. Tight labor markets continue to exert upward pressure on wages, while core inflation should be stable. We should see inflation remain anchored near the Fed’s 2.0% target.

Implications for Vanguard funds:

  • We are close to neutral in terms of our duration positioning as we expect a flatter curve with long-end yields anchored by slower growth and tame inflation. At this point in the economic cycle, we favor curve-steepening strategies, which should benefit as the Fed finishes raising rates and the market begins to contemplate rate cuts.
  • At year-end, we felt inflation expectations had fallen too low. We are now positioned for a rise in inflation expectations at the long end of the curve.
  • We are overweight MBS because valuations have improved and market supply-demand technicals are turning more positive.

Credit

Our outlook for the U.S. and global economies suggests a more challenging environment ahead for credit securities since we expect economic growth to slow and monetary policy in the United States to enter more restrictive territory. At this point in the cycle, we remain favorable on credit exposure to capture carry, but with a more defensive stance focusing on sectors and securities that are better equipped to navigate a slower growth environment.

Investment-grade1 corporates

Falling interest rates helped to offset nearly all the negative impact from the substantial spread widening across investment-grade issuers. The result was a fairly benign performance period for the sector. Lower-credit-quality securities underperformed, and energy-related companies were negatively affected by sharply falling oil prices. Improved valuations offer a better entry point, but downside risks remain as balance sheet leverage continues to be elevated across industrial firms and we expect slower corporate earnings growth going forward.

We are being more cautious within corporates, focusing on higher-quality issuers or, when appropriate, securities with shorter maturities. We maintain a more constructive view of financials and are avoiding industrial issuers with unsustainable levels of outstanding debt. Across industrial issuers, we will focus on companies that are making tangible progress on deleveraging with strong business models that have the capacity to pay down debt. We remain cautious of companies that rely on higher growth, synergies from acquisitions, or asset sales to improve their balance sheet position.

Structured finance

The asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) sectors outperformed all other parts of the credit market, driven by strong fundamentals and investor preference for higher credit quality. In our view, ABS continues to be supported by a strong U.S. consumer, and CMBS from stable property valuations and a favorable supply-demand dynamic.

We've shared our more guarded view of credit in prior writings and have expressed this posture through an overweight to ABS. The sector's more defensive characteristics proved to be beneficial during the fourth quarter's gyrations. We maintained an underweight to credit cards driven by unattractive valuations, with an overweight to senior and subordinate auto-related ABS. Despite the recent outperformance, we believe the sector continues to offer attractive risk-adjusted yields.

Emerging markets

Increased market volatility from a challenging global macroenvironment and a broader "risk off" sentiment translated into negative returns and considerable outflows from emerging markets (EM). EM benefited from being one of the first asset classes to react to changing monetary and economic conditions early in 2018. The repricing of risk in the sector makes it look more attractive relative to other credit sectors. We believe it can perform well in an environment with more benign U.S. monetary policy and a weakening U.S. economy. We continue to focus on higher-quality EM securities that we believe can absorb an economic slowdown and look for opportunities in lower-quality securities with compelling credit stories and policy credibility.

Credit spreads by sector

Credit spreads by sector

Source: Bloomberg Barclays indexes.

Regionally, we maintained an overweight to Latin American countries. Our views and positioning in Brazil contributed positively as the market became more optimistic over the newly elected president's chances for fiscal reform. Offsetting some of this impact was an overweight position in Mexico. Sentiment on the country's debt turned negative during the period as investors began to price in higher credit risks from the lack of clarity on how the incoming administration will finance its ambitious social and infrastructure programs.

High-yield corporates

Across the credit markets, below-investment-grade securities saw the sharpest increase in spread levels during the quarter. CCC-rated securities dramatically underperformed the B- and BB-rated segments of high yield as investors’ appetite for higher-risk corporate bonds reversed course from earlier in the year.

High-yield spreads are more attractive relative to their multiyear lows achieved in October. We view the recent spread widening as driven by a change in sentiment rather than a change in credit fundamentals, which haven’t eroded materially. We also expect default rates in high yield to remain below the historical average over the near term.

Our portfolios will maintain lower levels of risk in the sector given concerns around its sensitivity to U.S. economic deceleration. We will be selective as we look for higher-quality issuers with sound fundamentals and superior value.

Implications for Vanguard funds:

  • Overweight credit exposure overall, but with a more defensive stance given our outlook for a "down but not out" growth environment.
  • Leverage our experienced team of credit analysts to be highly selective within corporates. Continue to favor ABS and its higher relative credit quality, sound fundamentals, and strong, risk-adjusted returns.
  • We are more constructive on EM following better valuations and mostly stable-to-improving fundamentals. A less aggressive monetary policy environment should benefit the sector.

Municipal bonds

Municipal yields

The benign interest rate environment and strong technical backdrop that guided the municipal market during 2018 took a U-turn during the fourth quarter. Municipal yields rose considerably in October, triggering cash outflows that persisted for most of the quarter, before snapping lower in November and December. Increased volatility prompted investors to recalibrate their views on the future path of interest rates and reprice the fair value of credit risk. The high-quality focus of our funds, as well as our strategic positioning in premium callable securities, lent well to this environment of increased turbulence, lower yields, and modest credit repricing.

Muni-to-Treasury ratios continue to highlight strong demand for municipal bonds inside of 10 years, while longer-dated municipals remain at yields similar to those of Treasuries. We expect this steeper muni-Treasury ratio curve to persist under the new investor demand pattern spurred by the Tax Cuts and Jobs Act of 2017. On the supply side, we expect 2019 to look much like 2018, with continued growth in new money issuance and normal current refunding activity. While November midterm elections produced results in line with market expectations, we will continue to closely monitor budget proposals during the ensuing months, as well as several larger, voter-approved bond issuances.

Implications for Vanguard funds:

  • Maintain a duration-neutral tendency across funds, with allowance for minor tactical duration calls when seasonal or technical trends provide opportunities. For example, some portfolios began the year with a slightly longer duration to benefit from a period of strong reinvestment activity.
  • Continue to emphasize premium callable bonds, which provide more stability and better yield per unit of duration.

2018 Municipal fund cash flows

2018 Municipal fund cash flows

Source: Morningstar, Inc, as of December 31, 2018.

Municipal credit

Spreads in BBB- and high-yield-rated municipal bonds widened modestly during the quarter. We view this widening as driven by technical factors from cash outflows rather than a change in credit fundamentals, which we believe remain healthy. While valuations at wider spreads make lower-quality bonds marginally more attractive, we do not view this as an opportunity to add more credit risk. Rather, we continue to gradually upgrade the credit quality of our portfolios, capturing carry in the meantime while bracing for softer economic growth. Given healthy fundamentals across issuers, and a base case economic forecast of positive GDP growth in 2019, we do not view spreads as likely to materially widen in the near term.

The tobacco sector came under intense selling pressure during the period following the news of the FDA’s seeking to ban sales of menthol cigarettes. Our portfolios hold minimal tobacco exposure, due in part to these securities’ meaningfully higher risk from their complex structures and shifting consumer preferences. The small allocations that we do hold have been scrutinized and modeled by our robust credit research team. We hold issues that can withstand higher-than-average declines in tobacco-consumption rates. Across other sectors, we remain favorable on hospitals with considerable scale or limited competition, as well as on select private universities that are better positioned to withstand the changing higher education landscape.

Implications for Vanguard funds:

  • Continue to gradually upgrade the overall credit quality of the funds, leveraging the recommendations of our deep credit research team.
  • Look for opportunities to tilt away from more cyclically sensitive municipal sectors in favor of sectors that provide more inelastic services.

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 0.15%
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 0.19% VWSUX 0.09%
Limited-Term Tax-Exempt VMLTX 0.19 VMLUX 0.09
Intermediate-Term Tax-Exempt VWITX 0.19 VWIUX 0.09
Long-Term Tax-Exempt VWLTX 0.19 VWLUX 0.09
High-Yield Tax-Exempt VWAHX 0.19 VWALX 0.09
State municipal
California Intermediate-Term Tax-Exempt VCAIX 0.19% VCADX 0.09%
California Long-Term Tax-Exempt VCITX 0.19 VCLAX 0.09
Massachusetts Tax-Exempt4 VMATX 0.15
New Jersey Long-Term Tax-Exempt VNJTX 0.19 VNJUX 0.09
New York Long-Term Tax-Exempt VNYTX 0.19 VNYUX 0.09
Ohio Long-Term Tax-Exempt4 VOHIX 0.15
Pennsylvania Long-Term Tax-Exempt VPAIX 0.19 VPALX 0.09

BOTTOM LINE CONSIDERATIONS

Volatility is a stark reminder of the importance of properly aligning risk tolerance with strategic asset allocation. We remain committed to the idea that most investors seek stability from their bond portfolios and that most clients are best served by broadly diversified bond funds.

Taxable credit-sector valuations have cheapened, but we caution investors to evaluate the attractiveness of higher yield levels in concert with the looming risks of an economic slowdown. Higher-quality fixed income assets will provide the best counterweight to equity market volatility.

Municipals, as opposed to other pockets of the market, have historically been a haven for lower volatility because of their higher relative credit quality and insulation from global growth or geopolitical concerns. We believe they continue to represent attractive characteristics that investors should keep in mind when making broader portfolio investment decisions.

Download Vanguard active Fixed Income Perspectives

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, CFA
Principal and Global Head of Credit

Dan Larkin
Senior Product Manager-Taxable Bonds

Paul Malloy, CFA
Head of U.S.
Municipals

Ron Reardon
Principal and Head of U.S. Municipals

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

Data as of December 31, 2018.

Notes:

  • For more information about Vanguard funds, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
  • 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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