Actively navigate market uncertainty with passive bond ETFs

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Actively navigate market uncertainty with passive bond ETFs

Vanguard Perspective

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October 26, 2023

Given the increased focus on fixed income and Federal Reserve developments, you’re probably fielding questions from clients on the best way to build out their fixed income sleeves.

Uncertainty creates opportunity and fixed income ETFs have proven effective at finding liquidity in periods of uncertainty. There are three distinct ways that investors are using these narrow-fixed income ETFs in their portfolios. These include using passive ETFs to set core risk exposure (for example, duration and credit) cheaply and in a predictable manner, as a liquidity tool around other fixed income strategies, and to express a view on the market.

Passively invested, actively engaged

When you examine the rise of fixed income index ETFs, most of the growth (65%) has gone toward products that offer more targeted exposures (for example, short-term or specific sectors) that can help a fixed income portfolio achieve a specific risk profile that is different from the broad market. In other words, you are using passive products in an “active” way, highlighted in the chart below.

The left bar chart shows how indexing is growing in fixed income. June 2013 AUM: 15% passive, 85% active. June 2023 AUM: 36% passive, 64% active. 10-year cash flow growth: 74% passive, 26% active. The right bar chart shows that passive is often used actively. Niche: 65%. Core 35%

Source: Morningstar, Inc., as of June 30, 2023.

Notes: The figure on the right represents the percentage of passive fixed income ETFs that went toward "niche" and "core" products. Niche products offer concentrated exposure to a subset of the market. Core products provide broadly diversified exposure to primarily investment-grade bonds.¹ They can serve as the centerpiece of an investor's fixed income portfolio.

Navigate changing markets with the flexibility of bond ETFs

Given the persistent uncertainty, flexibility is key as you prepare for the prospect of a recession while looking carefully for opportunities of potentially reliable returns.

Our diverse lineup of bond ETFs enables you to invest in as few or as many ETFs as you see fit to complete the bond piece of a client’s portfolio. Each Vanguard bond ETF offers you low-cost access to a wide variety of bonds in a single investment.

You can recreate the government/credit portion of the Bloomberg Aggregate Index by investing in our short-, intermediate-, and long-term bond ETFs (BSV, BIV, BLV). Shifting allocations allows you to fine-tune a portfolio's interest rate and credit risk while maintaining exposure to the total U.S. bond market. You can also set your preferred sensitivity to credit risk by using our suite of corporate bond ETFs (VCSH, VCIT, VCLT).

Corporate bond ETF portfolio with a long-term tilt

(Hypothetical example)

This hypothetical example shows how our corporate ETFs can allow you to set your preferred sensitivity to credit risk by allocating 20% VCSH, 30% VCIT, 50% VCLT. And the chart shows you where on the maturity (x-axis) and yield (y-axis) these three allocations fall.

Consider Treasury ETFs for setting a portfolio duration target

Interest rate sensitivity is one of the larger drivers of fixed income portfolio return. While our research suggests that advisors focus greater attention on delivering higher yield through increased credit exposure, curve positioning can be another useful tool to reach a particular yield target. Some of the more common trends we see through our conversations with advisors are focused on:

Rising rates: Increasing rates/yields bring short-term pain but long-term gain. While increased exposure to cash and money markets has helped many investors avoid the bond sell-off over the last few years, a steepening yield curve led by long-term rates has created opportunities across bond maturities.

Economic outlook: Many investors have been hesitant to extend duration because shorter-term securities offer higher yields with lower interest rate risk. While that is certainly true today, longer-term bonds allow investors to “lock-in” higher yields for longer. If the economic backdrop weakens, investors in longer-term bonds can benefit from price appreciation as yields fall, while those in cash will only receive lower yields.

The chart below shows where current yields are on Treasury bonds as you go out longer on the duration spectrum or yield curve. We also identify the maturity ranges our three Treasury ETFs cover along the yield curve.

This line chart shows how you can get exposure to the yield curve with our Treasury ETFs by plotting the current yield for 1 yr. 4.7%, 2 yr. 5.0%, 3 yr. 4.8%, 5 yr. 4.6%, 7 yr. 4.7%, 10 yr. 4.6%, 20 yr. 5.0%, and 30 yr. 4.8% as of October 13, 2023.

Past performance is no guarantee of future results.

Source: U.S. Department of the Treasury Daily Treasury Par Yield Curve Rates as of October 13, 2023.

Take action: Find the right bond ETF to create the ideal risk profile to support your clients’ goals

Our bond ETF lineup offers you the benefits of low costs, a well-maintained secondary market, and a consistent effort to tightly track the market. With 21 ETFs across multiple fixed income sub-asset classes from Treasuries to corporates, munis to emerging markets—many of these sliced up based on maturity—you’ll be able to find an ETF to help you express your views on the market without being overwhelmed by the options.

The building blocks of a low-cost, diversified portfolio

Our bond ETFs offer full coverage of the fixed income universe.

1 A bond whose credit quality is considered to be among the highest by independent bond-rating agencies.

Notes:

For more information about Vanguard funds or Vanguard ETFs, obtain a prospectus (or a summary prospectus, if available) or call 800-997-2798 to request one. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments. U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.

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