Clients still in cash? It's time to talk to them about active bond ETFs

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Clients still in cash? It's time to talk to them about active bond ETFs

Vanguard Perspective

 | 

May 3, 2024

Sometimes, looking back can show you the way forward. When we apply that principle to interest-rate cycles, we see a strong pattern that suggests we're in a period where reallocating your clients from cash to fixed income may help them earn higher returns and safeguard their portfolios from potential equity volatility, as interest rates are still near 20-year highs.

We believe the Federal Reserve has reached the end of its rate hikes for this cycle. In the past, bonds have outperformed in periods like this, as you can see in this chart:

 

Historical performance shows that investment-grade bonds have performed well after the Federal Reserve has stopped raising rates.

This chart shows that the last four times the Fed stopped raising rates, Intermediate-Term Core Bonds, Intermediate-Term Core Plus Bonds, Municipal National Short-Term Bonds and Municipal National Intermediate-Term Bonds outperformed cash, as measured by T-bills, all four times. The data covers the period from February 1, 1995 to December 20, 2021.

Sources: Bloomberg data via FactSet. Intermediate core represented by Bloomberg U.S. Aggregate Bond Index. Intermediate core-plus represented by Bloomberg U.S. Universal Bond Index. Municipal national short-term represented by Bloomberg Municipal Short (1–5 Year) Index. Municipal national intermediate-term represented by Bloomberg Municipal Bond Index. T-Bills represented by Bloomberg U.S. Treasury 1–3 Month Index.

Notes: The one-year returns after rate hikes are complete, averaging the periods of February 1, 1995, to February 1, 1996; May 16, 2000, to May 16, 2001; June 29, 2006, to June 29, 2007; and December 20, 2018, to December 20, 2019. The three-year returns after rate hikes are complete, averaging the periods of February 1, 1995, to February 1, 1998; May 16, 2000, to May 16, 2003; June 29, 2006, to June 29, 2009; and December 20, 2018, to December 20, 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.

Waiting in cash may lower returns

Because the yield curve remains inverted, high rates on cash may tempt clients to wait, but that’s not a riskless decision. When the Fed eventually cuts its policy rate, cash rates quickly follow.  Clients may miss the moment and face reinvesting at much lower rates than they could get now on bonds.

Also, a higher starting yield on cash relative to bonds does not mean cash will outperform even in the near-term. In 2023, bonds beat cash. The Bloomberg U.S. Aggregate Bond Index outperformed Vanguard Treasury Money Market Fund by 48 basis points in the year ended December 31, 2023. This is because bonds with duration appreciate when rates fall, as they did in late 2023.

High equity valuations offer another reason to reallocate to fixed income. Adding duration with longer-term fixed income can help hedge against a decline in equities.

Choose index or active or both

Whether you want active or passive, mutual funds or ETFs, or a combination of them all, we offer a wide range of fixed income products to meet your clients’ individual needs.

Active fixed income may suit clients who:

  • Desire outperformance.
  • Have a higher tolerance for risk.
  • Prefer to partner with market experts to manage risk and identify opportunities for their fixed income portfolios.

With active funds, volatility also becomes opportunity. Our active managers seek to safeguard portfolios on the downside and take advantage of market dislocations to add value to your clients’ portfolios.

Active bond funds can help you capture a bigger slice of the bond market

Index funds are powerful tools for providing broad market exposure at low cost, driven in part by their exclusion of esoteric or illiquid sectors, issuers, or structures. The bond market is large and diverse with thousands of individual bonds. Its varied nature means indexes represent the overall risk factors of the underlying bond market but don’t include every single security like equity indexes do.

Consider the most common measure of the bond market, the Bloomberg U.S. Aggregate Index (the Agg). It covers only the U.S. bond market, which represents only 40% of fixed income globally. The Agg also is underweight several sub-asset classes, as this chart shows.

 

What's in and out of the Agg?

This chart shows that the the most common measure of the bond market, the Bloomberg U.S. Aggregate Index (the Agg), does not include large portions of the bond market. The Agg does not covers 35% of the investment-grade bond market, 43% of the Mortgage-backed securities market, 52% percent of the U.S. Treasury market, 70% of the government agencies market, 92% of the Government Agencies market or any of the municipal market.

Source: Bloomberg and Securities Industry and Financial Markets Association data, as of December 31, 2021, the latest year for which complete data is available.

For clients who want to look beyond the index, you can, of course, assemble a portfolio of index funds to target larger swaths of the bond market, but that option may require additional time and research for your team.

Active bonds can help you conquer this challenge and others. With Vanguard active fixed income, you get a team of experts that can help you increase your clients’ chances of outperformance by:

  • Offering exposure to areas of the bond market that aren’t in the index.
  • Deciding when to lean into or out of different bonds, issuers, or sectors.
  • Tilting the portfolio’s key risk exposures, durations, and credit. 

Improve client outcomes with the three Ts of ETFs

Money has been flowing into ETFs because they offer three clear benefits compared to mutual funds:

  • Potential tax efficiency.
  • Greater portfolio transparency.
  • The ability to trade during the day.

For clients who put a high value on these three Ts (tax efficiency, transparency, and tradability), ETFs may be the most suitable option.

Consider Core and Core-Plus for your clients’ primary bond allocations

Exploring our three active bond ETFs can help you get started on the path to adding duration.

Vanguard Core Bond (VCRB) and Vanguard Core-Plus Bond (VPLS) are active fixed income ETFs that can serve as a single-fund fixed income holding. They both provide actively managed exposure to the broad U.S. fixed income market and are diversified across a range of sectors, credit qualities, and maturities.

For both ETFs, the majority of alpha is expected to be driven by sector allocation, as managers overweight or underweight U.S. Treasuries, mortgage-backed securities, investment-grade corporates, emerging markets, and high-yield bonds. Individual security selection will also add to alpha generation.

VCRB focuses primarily on investment-grade corporate bonds, Treasuries, and agency mortgage-backed securities, with only selective exposure to high-yield, emerging markets, and non-U.S. corporate bonds. Its benchmark is the Bloomberg U.S. Aggregate Float Adjusted Index.

VPLS can work as a core bond holding for clients who have a higher appetite for risk and potential outperformance. It’s benchmarked against the Bloomberg U.S. Universal Index (known as the "Universal"), which has greater exposure to lower quality bonds, structured products, and other, less mainstream, bond sectors than the Agg. It also provides exposure to U.S. government debt and investment-grade corporates but has greater flexibility than VCRB to invest in high-yield corporate and emerging markets bonds.

Look beyond cash with our Ultra-Short Bond ETF

Vanguard Ultra-Short Bond ETF (VUSB) gives your clients an alternative for funds they will need in the next 6 to 18 months. It invests in short-term, investment-grade fixed income securities. With an expense ratio of just 0.10%, VUSB seeks current income with limited price volatility.

With a duration of one year, VUSB may help you nudge hesitant clients out of cash and into fixed income.

With Vanguard, you and your clients can count on funds that stick to their investment mandates. Our lower costs enable us to take risk only when our investors will be appropriately compensated.

Check out our active fixed income ETFs

For more information about Vanguard funds or Vanguard ETFs, 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 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. 

Vanguard is owned by its funds, which are owned by Vanguard’s fund shareholder clients.

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. 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. 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.

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