Active Fixed Income Perspectives: Q2 2021

April 29, 2021 | Vanguard Perspective

Active Fixed Income Perspectives: Q2 2021

Key highlights

  • Performance: The expected rise in longer-maturity U.S. Treasury yields created a bear market for interest rates and led to challenging conditions across fixed income. Credit spreads remain rich by historical measures.
  • Looking ahead: We'll be watching for higher, and more persistent, realized inflation—a key risk factor.
  • Approach: We remain cautious and patient. Near-term opportunities exist in higher-quality financials and some select mid-quality cyclical issuers. Inflation should surge this spring and early summer. However, we don't expect this temporary surge to turn into runaway inflation over the medium term.

Patience remains the watch word

This was a broadly negative quarter for bonds, and we expect the volatility to continue. The long end of yield curves across developed markets steepened significantly this past quarter, creating a bear market for interest rates. In the U.S., the yield on the 10-year Treasury note increased more than 80 basis points over the quarter and more than 100 basis points since the first quarter of last year.

Credit spreads remain historically tight, and inflation concerns are high. Yields may still rise and curves may get steeper, but we don’t foresee a 10-year Treasury yield much above 2% in the near term, given current conditions.

It seems clear to us that this is a time for patience.

Can fixed income still play a role?

Your clients may be questioning the value of including fixed income investments in their portfolios. We disagree with those who suggest abandoning fixed income, especially in exchange for more exotic—and usually more expensive—alternatives. We believe fixed income can still provide diversification against equity risk in your clients’ portfolios.

If the roaring stock market stumbles—as it did in 2020—we expect that fixed income will prove itself again.

Taxable Q1 2021 fixed income sector returns

This is a vertical bar chart showing taxable fixed income sector returns for the first quarter of 2021. For U.S. high-yield, the first-quarter total return was 0.85%; for U.S. asset-backed securities, the total return was –0.16%; for U.S. mortgage-backed securities, the total return was –1.10%; for U.S. commercial mortgage-backed securities, the total return was –2.32%; for global aggregate credit, the total return was –3.08%; for U.S. aggregate, the total return was –3.37%; for U.S. Treasury, the total return was –4.25%; for Emerging markets (in USD), total return was –4.54%; and for U.S. corporates, the total return was –4.65%Sources: Bloomberg Barclays indexes and J.P. Morgan EMBI Global Diversified Index, as of March 31, 2021.

Sources: Bloomberg Barclays indexes and J.P. Morgan EMBI Global Diversified Index, as of March 31, 2021.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Implications for your clients' portfolios

Rates and inflation

Market pricing has pulled forward expectations for future rate hikes, which are running well ahead of the Federal Reserve’s forward guidance. Near the end of the quarter, the market saw the next rate hike in the fourth quarter of 2022 and as many as three hikes in 2023. By comparison, the Federal Open Market Committee (FOMC) does not anticipate raising rates before 2024.

We remain positioned for a modest move higher in yields. But after such a large move in the first quarter, we see rates more range-bound for now.

Inflation expectations

The FOMC's Summary of Economic Projections released in mid-March revised its core inflation forecast upward to just above 2% for each year through 2023. We expect the Fed to remain accommodative.

We see value in front-end breakeven inflation exposure as the fundamental backdrop remains strong and inflation risks are skewed to the upside.

Mortgage-backed securities (MBS)

Longer durations, higher interest rate volatility, and a steeper Treasury yield curve keep us less constructive on MBS broadly, and we have reduced our exposure. We believe the Fed is unlikely to withdraw its support for MBS purchases because they are a direct way for monetary policy stimulus to reach households.

The path ahead for MBS is challenging, but a bottom-up focus on security selection can add value in a more volatile market.

Credit markets

Credit-sector spreads traded within a tight range during the quarter, doing little to help offset the negative impact of rising interest rates. Apart from below-investment-grade corporates, which benefited from investors’ seeking refuge from rising rates, most credit sectors posted negative returns.

It's time to be restrained in credit. Spreads are compressed and the lowest-quality segments are most exposed to a shift in risk sentiment and/or a setback in the economic recovery.

Q1 credit spreads trade in tight range after 2020 compression

In basis points (bps), from March 31, 2020, through March 31, 2021

This is a series of seven line graphs showing credit spreads for emerging markets (USD) sovereigns, U.S. high-yield, U.S. corporates global aggregate credit, U.S. CMBS, U.S. ABS, and U.S. MBS from March 31, 2020, to March 31, 2021, in basis points. Each shows that credit-sector spreads traded within a tight range in the first quarter, after a dramatic compression last year. Emerging markets (USD) sovereigns spread levels began the period at 626 bps and finished at 354 bps; U.S. high-yield began the period at 800 bps and finished at 310 bps; U.S. corporates began the period at 266 bps and ended at 95 bps; Global aggregate credit began the period at 247 bps and finished at 88 bps; U.S. CMBS began the period at 188 bps and finished at 71 bps; U.S. ABS began the period at 213 bps and finished at 35 bps; and U.S. MBS began the period at 60 bps and finished at 12 bps. Sources: Bloomberg Barclays indexes and J.P. Morgan EMBI Global Diversified Index, as of March 31, 2021.

Sources: Bloomberg Barclays indexes and J.P. Morgan EMBI Global Diversified Index, as of March 31, 2021.

Investment-grade corporates

It could have been a worse quarter for credit, considering that starting valuations were in the first percentile for the 10 years ended December 31, 2020, and a glut of new issuance arrived to start 2021. Still, investor cash flows into the sector soaked up supply. Improving corporate fundamentals and strong policy support for risk assets also helped.

Spreads are likely to remain range-bound in the near term. We see the best opportunities across corporate bonds in cyclically exposed BBB and BB issuers with strong fundamentals, but we expect security selection to drive performance.

High-yield corporates

CCC rated securities have outperformed their higher-quality peers for several months. Most of these new CCC rated companies are using their cash reserves due to the pandemic but are otherwise decent businesses with stronger long-term prospects than typical CCC issuers.

Nonetheless, we are cautious on high yield. The extra compensation for going down in quality in high yield is unattractive, though the recent underperformance of BBs presents some new opportunities.

Emerging markets (EM)

Both EM rates and currencies markets performed poorly in response to higher U.S. Treasury yields.

EM central banks pivoted toward tighter monetary policy, with both Brazil’s and Russia’s central banks raising interest rates as a response to high inflation. Local rates exposure could offer better value later as other central banks follow suit. That value will be realized only if real rates are positive, if rates are attractive relative to developed markets, and if local inflation comes under control.

EM bonds may face challenges over the short-term. We’ve reduced our overall EM risk across strategies, but we believe that idiosyncratic opportunities are present across the quality spectrum and that the long-term attributes of the asset class remain compelling.

Structured products

A lower amount of new-issue supply and light inventory on dealer balance sheets continue to be the main story line for both asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS).

With much of the structured products market linked to the U.S. consumer, we are paying close attention to the underlying fundamentals of borrowers. The U.S. unemployment rate is roughly double what it was at this time last year. However, consumer financial health appears to be positive.

For the 10 years ended December 31, 2020, the RCA US National All Property Index increased 122%. While the COVID-19 pandemic did have a substantial negative impact on short-term cash flows for many CMBS property types, the widespread increase in property values should help borrowers as they refinance.

Municipal yields

The American Rescue Plan Act, as well as the December 2020 COVID-19 relief bill, provide tremendous financial support to the municipal market and significantly buttress municipal creditworthiness. But the aid will also help spur an economic recovery, which can potentially create upward pressure on muni yields.

We continue to be mindful of overall interest rate risk in this environment. Since the New Year, we have modestly shortened durations across our funds while staying true to each fund’s respective mandate. This leaves us with ample dry powder to capitalize on opportunities if an outflow cycle ensues.

Municipal credit

Credit fundamentals should continue to improve throughout 2021, bolstered by the vaccine-driven economic reopening and augmented significantly by stimulus funds. Internally, our analyst team rates every issuer we own, and we see broad-based credit strengthening ahead.

We continue to view overall credit risk as attractive. We will add to opportunities that our analysts and traders find relatively attractive, particularly in sectors tied to higher education and travel.

Active fixed income research team

  • Christopher Alwine

    Christopher Alwine, CFA
    Principal and Global Head of Credit

    Christopher Alwine

    Christopher Alwine, CFA
    Principal and Global Head of Credit


    Christopher Alwine is a principal and global head of credit in Vanguard's Fixed Income Group, where he oversees portfolio management and trading teams in the United States, Europe, and Asia-Pacific for active corporate bond, structured product, and emerging markets bond portfolios. He joined Vanguard in 1990 and has more than 20 years of investment experience.

    Mr. Alwine was previously head of Vanguard's Municipal Group. There, he led a team of 30 investment professionals who managed over $90 billion in client assets across 12 municipal bond funds. He has served in multiple roles throughout his career in the Fixed Income Group. His experience includes trading, portfolio management, and credit research. Mr. Alwine's portfolio management experience spans both taxable and municipal markets, as well as active and index funds. He is also a member of the investment committee at Vanguard that is responsible for developing macro strategies for the funds.

    Mr. Alwine earned a bachelor's degree in business administration from Temple University and an M.S. in finance from Drexel University. He holds the Chartered Financial Analyst® certification.

  • Dan Larkin

    Dan Larkin
    Senior Product Manager–Taxable Bonds

  • Paul Malloy

    Paul Malloy
    Vanguard Head of Municipals

    Paul Malloy

    Paul Malloy
    Vanguard Head of Municipals


    Paul Malloy is head of municipal investment at Vanguard. Previously, he was head of Vanguard Fixed Income Group, Europe. In this role, Mr. Malloy managed portfolios that invested in global fixed income assets. He also oversaw Vanguard's European Credit Research team. Mr. Malloy joined Vanguard in 2005 and the Fixed Income Group in 2007 and has held various portfolio management positions in Vanguard's offices in the United Kingdom and the United States. In past roles, he was responsible for managing Vanguard's U.S. fixed income ETFs as well as overseeing a range of fixed income index mutual funds.

    Mr. Malloy earned an M.B.A. in finance from the Wharton School of the University of Pennsylvania and a B.S. in economics and finance from Saint Francis University. He is a CFA® charterholder.

  • Torre Swanson

    Torre Swanson, CFA
    Senior Product Manager–Municipal Bonds

Active fixed income leadership team

  • Christopher Alwine

    Christopher Alwine, CFA
    Principal and Global Head of Credit

    Christopher Alwine

    Christopher Alwine, CFA
    Principal and Global Head of Credit


    Christopher Alwine is a principal and global head of credit in Vanguard's Fixed Income Group, where he oversees portfolio management and trading teams in the United States, Europe, and Asia-Pacific for active corporate bond, structured product, and emerging markets bond portfolios. He joined Vanguard in 1990 and has more than 20 years of investment experience.

    Mr. Alwine was previously head of Vanguard's Municipal Group. There, he led a team of 30 investment professionals who managed over $90 billion in client assets across 12 municipal bond funds. He has served in multiple roles throughout his career in the Fixed Income Group. His experience includes trading, portfolio management, and credit research. Mr. Alwine's portfolio management experience spans both taxable and municipal markets, as well as active and index funds. He is also a member of the investment committee at Vanguard that is responsible for developing macro strategies for the funds.

    Mr. Alwine earned a bachelor's degree in business administration from Temple University and an M.S. in finance from Drexel University. He holds the Chartered Financial Analyst® certification.

  • Joe Davis

    Joe Davis
    Vanguard Global Chief Economist

    Joe Davis

    Joe Davis
    Vanguard Global Chief Economist


    Joseph Davis, Ph.D., a Vanguard principal, is the global chief economist and global head of Vanguard Investment Strategy Group, whose research and client-facing team develops asset allocation strategies and conducts research on the capital markets, the global economy, portfolio construction, and related investment topics. Mr. Davis also chairs the firm's Strategic Asset Allocation Committee for multi-asset-class investment solutions. As Vanguard's chief economist, Mr. Davis is a member of the senior portfolio management team for Vanguard Fixed Income Group. He is a frequent keynote speaker, has published white papers in leading academic and practitioner journals, and helped develop Vanguard Capital Markets Model® and the firm's annual economic and capital markets outlook. Mr. Davis earned his B.A. summa cum laude from Saint Joseph's University and his M.A. and Ph.D. in economics at Duke University.

  • Sara Devereux

    Sara Devereux
    Vanguard Global Head of Rates

    Sara Devereux

    Sara Devereux
    Vanguard Global Head of Rates


    Sara Devereux is a principal and head of Global Rates in Vanguard Fixed Income Group. Ms. Devereux has oversight responsibility for investment activities within the rates-related sectors of the taxable fixed income market including foreign exchange. Prior to joining the firm, Ms. Devereux was a partner at Goldman Sachs, where she spent over 20 years in mortgage-backed securities and structured product trading and sales. Earlier in her career, she worked at HSBC in risk management advisory and in interest rate derivatives structuring. Ms. Devereux started her career as an actuary at AXA Equitable Life Insurance. Ms. Devereux earned a B.S. in mathematics from the University of North Carolina at Chapel Hill and an MBA from the Wharton School of the University of Pennsylvania.

  • John Hollyer

    John Hollyer, CFA
    Principal and Global Head of Fixed Income Group

    John Hollyer

    John Hollyer, CFA
    Principal and Global Head of Fixed Income Group


    John Hollyer, CFA, is a principal and global head of Vanguard Fixed Income Group, which manages over $1 trillion in assets. He is responsible for the group's portfolio management, strategy, credit research, trading, and planning functions. He joined the company in 1989 and previously served as head of the Risk Management Group, which focuses on global investment and operational risk issues for Vanguard Investment Management Group. Mr. Hollyer has also served as portfolio manager for a number of Vanguard's bond and money market funds.

    Mr. Hollyer, who has nearly 30 years of investment management experience, is a CFA® charterholder and has a B.S. in economics from The Wharton School of the University of Pennsylvania.

  • Paul Malloy

    Paul Malloy
    Vanguard Head of Municipals

    Paul Malloy

    Paul Malloy
    Vanguard Head of Municipals


    Paul Malloy is head of municipal investment at Vanguard. Previously, he was head of Vanguard Fixed Income Group, Europe. In this role, Mr. Malloy managed portfolios that invested in global fixed income assets. He also oversaw Vanguard's European Credit Research team. Mr. Malloy joined Vanguard in 2005 and the Fixed Income Group in 2007 and has held various portfolio management positions in Vanguard's offices in the United Kingdom and the United States. In past roles, he was responsible for managing Vanguard's U.S. fixed income ETFs as well as overseeing a range of fixed income index mutual funds.

    Mr. Malloy earned an M.B.A. in finance from the Wharton School of the University of Pennsylvania and a B.S. in economics and finance from Saint Francis University. He is a CFA® charterholder.

  • Anne Mathias

    Anne Mathias
    Head of Global Rates and FX Strategist

    Anne Mathias

    Anne Mathias
    Head of Global Rates and FX Strategist


    Anne N. Mathias is a senior strategist in Vanguard Fixed Income Group, with a focus on global macro rates and foreign currency. She is responsible for analyzing interest rates, currency valuations, economic developments, and political risks for Vanguard's portfolio managers and investment staff.

    Before joining Vanguard in 2017, Ms. Mathias was the senior macro strategist for Guggenheim Partners Investment Management in Los Angeles. She also spent an earlier part of her career on the sell side, producing her own research and managing U.S.-based research teams for MF Global, Charles Schwab, and others. In these roles, she led the Washington Research Group team which provided political, economic, and industry research for investors and was consistently ranked among the top three in the Institutional Investor \"All-America Research Team\" poll. Ms. Mathias was a private equity investor with the Global Environment Fund and spent five years with Deloitte & Touche as a senior consultant specializing in emerging market privatization and enterprise restructuring.

    Ms. Mathias earned a B.A. from the University of Maryland and an M.S. in international affairs from Georgetown University's School of Foreign Service. She is a CFA® charterholder and a member of the CFA Society of Los Angeles and the CFA Institute.

  • Manish Nagar

    Manish Nagar
    Global Head of Risk Management Group

    Manish Nagar

    Manish Nagar
    Global Head of Risk Management Group


    Manish Nagar is a principal and the global head of Vanguard Risk Management Group, a subdivision of Global Risk and Security, responsible for the execution, coordination, and evolution of the company's risk and quantitative processes across all global markets. Prior to this role, Mr. Nagar was global head of investment risk; prior to that, he was head of risk management in Europe, where he was responsible for investment and operational risk oversight of the U.K. and Irish fund range. Mr. Nagar joined Vanguard in 2000 and has held various positions of increasing responsibility within the Planning and Development, Information Technology, and Investment Management Divisions, along with numerous special assignments.

    Mr. Nagar earned a bachelor's degree in electronics and communication engineering from Bangalore University, in India, and an M.B.A. from Rutgers University, in the United States. A graduate of the Executive Masters in Technology Management (EMTM) program at the University of Pennsylvania (co-sponsored by The Wharton School), he also completed the Advanced Leadership Program at the Stanford University Graduate School of Business and attended the Investment Management Workshop at Harvard Business School.

AFI facts

* Includes funds advised by Wellington Management Company LLP.

Note: Data as of March 31, 2021. 

Notes:

  • Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.
  • 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.