Help clients get the fit they need with our core bond funds
June 6, 2023
June 6, 2023
Editor’s note: With interest rates continuing to headline market news, we sat down with two portfolio managers of Vanguard Core and Core-Plus Bond Funds to get their assessment of the markets and find out how they are managing in the current environment.
Q: Fixed income markets and interest rates have continued to be volatile in 2023. Is it better to sit in cash and wait?
Brian Quigley: We think bond yields are broadly attractive for long-term investors, providing adequate compensation for volatility. Money markets may offer an attractive yield currently, but we recommend longer-term fixed income if you believe a recession may start sometime in the next year. Core or core-plus bond funds are designed to provide higher yields over a longer time horizon, and historically these types of funds have helped stabilize client portfolios when equity market volatility strikes.1 You don’t get the same benefits from money markets.
Q: Is this a good time to go into fixed income? If so, why?
Daniel Shaykevich: While we don’t encourage investors to try to time markets, entry levels do matter. When you increase your allocation to longer-term bonds, you’re locking in the current level of yields for many years. Many investors and financial institutions that locked in low yields in 2020 or 2021 have suffered significant mark-to-market losses.
But the same dynamic can work in reverse, and getting into the bond market at attractive levels can generate capital gains. At the higher levels of interest rates we have today, bond funds can be attractive both outright and relative to other asset classes. Looking beyond the safest government bonds to credit, I would argue that even the riskiest segments of the credit markets could have substantial upside right now and appear more attractive than, say, defensively oriented stocks, with lower volatility.
Q: The Fed has hiked rates faster than it has in many decades. What is your outlook for Fed policy, and how do you trade in this environment?
Quigley: We are most likely at or near the end of this Fed hiking cycle. We believe now is the time to add high-quality fixed income exposure. While the risks of an economic slowdown are rising, our base-case view is that a recession won’t start for another quarter or two. If that turns out to be accurate, we expect volatility to decline and investment-grade bonds to perform well.
Q: How are these funds positioned?
Shaykevich: We are defensive right now. In Vanguard Core Bond Fund, we have trimmed our exposure to sectors that may not hold up as well in a recession, such as high-yield corporates. We have also offset some of our remaining high-yield corporate exposure via derivatives. This helps safeguard our portfolio against potential underperformance for lower-rated bonds while preserving our team’s ability to add value through security selection. We have added to higher-quality corporates that are less cyclical and more recession-proof, and we continue to maintain dry powder for better relative value opportunities in the future.
Q: Where do you see opportunities to add value in the medium term?
Quigley: There’s a tide change happening in mortgage-backed securities (MBS) right now. Banks have been major buyers of MBS over the past decade due to favorable regulatory treatment, but rising interest rates have caused heavy mark-to-market losses, which have contributed to some recent bank failures. Banks are likely to buy less MBS in the future, creating an opportunity for us to buy at lower prices.
We also think commercial mortgage-backed securities (CMBS) are due for more underperformance, and we have reduced our CMBS allocation over the past year. Our funds are positioned to take advantage of better CMBS opportunities when they emerge.
Shaykevich: Broadly in CMBS, we’ve seen term premium return in the high-quality structures, but not enough premium for the small (but nonzero) possibility that even investors in the most overcollateralized CMBS structures may experience capital losses. We think there’s still fear that needs to be priced into bonds due to risks related to end-of-cycle behavior and a potential recession. If losses exceed historical levels, those bonds will be at levels that are much more attractive.
We don’t mind taking risk as long as our clients are appropriately compensated.
Q: How could these funds perform as the economy evolves?
Quigley: If historical patterns continue, the Core Bond Fund should perform well because duration is expected to generate positive returns if rates fall. Credit spreads on investment-grade and high-yield corporate bonds would likely widen in a recession, allowing us to add more credit risk. In such a scenario, the market would be even more favorable for Core-Plus, which can take higher allocations to sectors like high yield and emerging markets.
Q: What are the differences between Core and Core-Plus?
Shaykevich: Both Core and Core-Plus can be foundational pieces for a diversified fixed income portfolio. The funds offer two different approaches for building a fixed income portfolio.
You can go for our Core-Plus Bond Fund, which invests in a broader range of sub-asset classes than our Core Bond Fund. Choosing Core-Plus is like hiring an interior designer to pick your colors, furniture, and window treatments—in this case, it’s choosing a manager to decide on a suitable portfolio for today’s market risks and opportunities. The Core-Plus investment universe includes not only traditional investment-grade corporates and Treasuries, but also lower-rated corporate bonds, international and emerging markets bonds, and various structured products.
For clients looking for a more conservative option, or for those who want to choose their own “plus” allocations, you may want to consider the Core Bond Fund. The Core Bond Fund can be supplemented when an advisor, or a client, chooses their own so-called window treatments and furniture; they might want to add a high-yield, emerging markets, or a global fund.
Quigley: It’s also a decision between risk appetites, and a decision to outsource to Vanguard as to when, and how much, to allocate to the “plus” sectors. We are experts—we are observing valuations in real time, and we’re well-positioned to make the decisions about how much risk to take on in which market opportunity.
Q: How does your approach compare with others in the industry?
Shaykevich: Our Core fund is designed as a conservative product, an investment-grade product, with less than 5% exposure below investment grade. We don’t try to find backdoor ways to add risk to that fund by using various structures that might have investment-grade ratings but more than an investment-grade level of risk. We try to run the Core fund as true-to-label so that it has a level of risk similar to its benchmark, the Bloomberg U.S. Aggregate Float-Adjusted Index.
In Core-Plus, I do think we are somewhat different from industry peers in that we do not have a sector tilt. We don’t feel like the risk of the fund has to be consistently high. Core-Plus can look more like a regular core bond fund when the risk premia in some of these additional asset classes simply aren’t attractive enough, and then we can get more aggressive when the time is appropriate.
Quigley: At Vanguard, we have managed active bond funds for more than 30 years and developed highly specialized teams which span the spectrum of fixed income sectors. Now, we can take these capabilities and deploy them in these two funds. We strive to find the best relative value opportunities across various sectors—whether it’s in MBS, credit, or elsewhere—and position the funds accordingly.
1 Morningstar, Inc., correlation data for the 15 years ended March 31, 2023.
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 are contained in the prospectus; read and consider it carefully before investing.
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. Past performance is no guarantee of future results.
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.
Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. 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.
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