How active core bond funds can help clients now

Executive summary:

• With the Federal Reserve having likely ended the hiking cycle, and bond yields near the top of the 20-year range, advisors should consider locking in yields for longer. Historically, bonds have performed much better than cash after rate hikes end.
• We are overweight to spread sectors in our core strategies due to the combination of strong investor demand for fixed income, solid credit fundamentals, and a resilient economy.
• Vanguard offers both Core and Core+ investment strategies in mutual fund and ETF forms, with Vanguard Core-Plus ETF and Vanguard Core-Plus Bond Fund using a broader index to better reflect the opportunity set for active managers.

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Q: Many fixed income commentators, including Vanguard, have been saying for months that it’s time to reallocate to bonds to lock in higher yields. What are your thoughts on that?

Daniel Shaykevich: If you switched to cash two years ago and stayed there, you don’t regret that decision—but rates today are at much higher levels and the economic cycle is more mature. As we saw last November and December when economic data began to point toward lower inflation and a softening labor market, rates can drop swiftly. At this point, if your client is a long-term investor, why keep them in cash?

We think we’ve seen the peak in yields for the cycle. It makes sense for investors with long-term horizons to move out of cash, extend out the yield curve, and lock in these multi-decade highs in yields.

Q: What is the Vanguard team’s expectation for fixed income this year?

Brian Quigley: Typically, the end of Fed hiking is an ideal long-term buying opportunity for fixed income. In the past four hiking cycles, returns for U.S. bonds exceeded that of cash over the one- and three-year periods following the Fed’s final rate hike. This historical precedent, and the high level of yields that are available now, leave us bullish on fixed income.

Bonds across the curve continue to offer attractive yields, and as you invest further out the yield curve, you can access possibly greater potential for price appreciation and protection against equity volatility.

Current strategies in Vanguard Core and Core-Plus Bond Funds

Q. Can you talk about how the funds are positioned to take advantage of this environment?  What are some of our top strategies?

Brian Quigley: Our funds are now positioned a little longer in duration than their benchmarks and to benefit from a steepening yield curve. Fed rate cuts should lower yields in the short and intermediate parts of the yield curve more than the long end. Mortgage-backed securities (MBS) valuations are fair, but with the two biggest holders of MBS—the Fed and banks—having pulled back from the sector, the technical picture remains challenged. We plan to remain tactical to take advantage of volatility.

Daniel Shaykevich: We came into the year with the vast majority of our credit allocation in U.S. investment-grade corporates. We continue to like companies with high-quality earnings and lean toward noncyclical subsectors such as food and beverage, pharma, and health care. Among banks, we like large regionals. Generally, we see more relative value in intermediate-term corporate bonds, as opposed to long- or short-term bonds. 

Recently, we’ve seen U.S. investment-grade credit spreads compress, and we expect most of the returns going forward to come from carry and a broader drop in bond yields. At the same time, emerging markets (EM) bond spreads widened early this year on heavy primary market issuance. We were very lightly positioned in EM and used this opportunity to add mostly to investment-grade EM names. This trade has already started to pay off. We also maintain some exposure to EM local currency bonds, with larger positions in our Core-Plus products. 

Q. What can go wrong?

Brian Quigley: While not our base case, there are scenarios that could result in the Fed hiking rates again. If economic growth continues to surprise to the upside, data pointing to higher inflation could force the Fed’s hand. While this would result in some near-term pain for fixed income markets, it would ultimately speed up the end of the economic cycle and increase the likelihood of a hard landing. For that reason, any increase in yields on longer-term fixed income in this scenario will be temporary, with yields ultimately ending up lower than where they are today.

Daniel Shaykevich: These are actively managed funds, so we view any surprises or market volatility as an opportunity to add value. Fundamentally, higher-quality companies are well positioned to weather all but a deep recession. However, credit spreads can certainly widen if economic growth decelerates suddenly or if the Federal Reserve is forced to hike rates unexpectedly to manage inflation. That’s why we remain cautious on U.S. high-yield credit, with light positioning even in our Core-Plus products. 

It’s also worth mentioning that our credit research team’s fundamental analysts work to identify and avoid the most vulnerable credits. If volatility does hit, the funds have plenty of dry powder to add credit risk at more attractive levels.

Q. Is there any significant difference between core and core-plus bonds?

Daniel Shaykevich: Vanguard Core Bond Fund and the new Vanguard Core Bond ETF seek to outperform the Bloomberg Aggregate Bond Float-Adjusted Index (the “Agg”), which mostly includes U.S. Treasuries, agency MBS, and investment-grade corporates.

The Bloomberg Universal Index that we use as the benchmark for the Core-Plus Fund and Core-Plus ETF has more comprehensive exposure to the bond market. In addition to the same coverage as the Agg, the Universal adds U.S. high-yield corporates and greater allotment to structured products and emerging markets. These sectors have more credit risk, but often less interest rate risk and can be slightly less liquid. They also tend to offer high yields and greater opportunity for selection and allocation decisions for active managers.

Many active core-plus managers use the Agg as a benchmark despite taking credit risk similar to or above the riskier Universal Index. We think the Universal better represents our Core-Plus fund’s investment universe.

When our Core-Plus products are defensively positioned, we are likely to maintain smaller exposures to “plus” sectors and remain focused on adding value through security selection.  When we believe the market offers more value, the fund is likely to have a larger portion in these higher-yielding sectors. Compared to our Core Bond products, our Core-Plus products are going to be more exposed to credit risk and likely to see their allocation to riskier bond sectors fluctuate significantly over time.

Learn more about Vanguard’s Core and Core-Plus mutual funds and ETFs

Core:

VCOBX – Core Bond Fund Admiral Shares

VCRB – Core Bond ETF

Core-Plus:

VCPAX – Core-Plus Bond Fund Admiral Shares

VPLS – Core-Plus Bond ETF

Read our latest Active Fixed Income perspectives, our quarterly in-depth commentary.