Active Fixed Income Perspectives Q3 2024: The high road
Vanguard Perspective
|July 26, 2024
Vanguard Perspective
|July 26, 2024
Vanguard Active Fixed Income Perspectives is our quarterly in-depth commentary. It offers a sector-by-sector analysis and a summary of how those views affect the Vanguard active bond funds.
Performance: Bond yields initially moved higher in the second quarter in response to hotter-than-expected inflation readings early in the year, but then drifted down as growth and inflation moderated. Lower-quality credit performed best as spreads widened modestly across taxable sectors and narrowed in municipals.
Looking ahead: Inflation has decelerated to levels that now allow the Federal Reserve to cut interest rates if needed, which improves the total-return prospects for bonds. We don’t foresee significant Fed easing in 2024, but investors shouldn’t miss the opportunity to lock in attractive yields and potentially benefit from the price appreciation that would occur when rates eventually decline.
Approach: All-in yields remain attractive across fixed income sectors, but tight spreads keep us cautious about below-investment-grade risk.
Tax-exempt credit still offers more room for spreads to tighten. Higher-rated municipal bonds look rich because of separately managed account (SMA) buying, but considerable value remains, especially in the middle tiers of credit.
Taking the high (quality) road
In her book How to Decide: Simple Tools for Making Better Choices, cognitive psychology expert Annie Duke says: “Most decisions have a mix of upside and downside potentials. When figuring out whether a decision is good or bad, you are essentially asking if the upside potential compensates for the risk of the downside.”
We are always asking that question. Getting to the right answer, however, requires an assessment of potential market outcomes well beyond a base case view. For us, constructing optimal portfolios starts with a detailed analysis across a range of economic scenarios. A probability-weighted approach provides a better foundation to identify opportunities and manage risks.
In recent months, the worst-case fear for bonds—a reacceleration in inflation and likely higher interest rates—has faded. Growth indicators have been somewhat mixed, but there are more signs of weakness and recent inflation readings have been lower than expected.
We believe we are approaching a turning point in the economic cycle, which historically has been a good environment for higher-quality bonds. In our view, the risk of a near-term downturn is still low, but we are mindful that a prolonged period of restrictive policy rates poses a risk to the most vulnerable fixed income segments, where most of the good news has been priced in.
Investors should note that real interest rates—the expected return from yields after expected inflation is subtracted—remain near recent historical highs. The entire real yield curve is higher today than it was a year ago and two to three percentage points higher than the day before the Fed started raising rates.
Higher starting yields imply higher returns and better downside hedging. Even if rates generally moved up, higher yields today—relative to the beginning of 2022—can cushion losses from price changes.
Rates and inflation
It’s been almost a year since the Fed last raised its policy rate. Despite substantially higher borrowing costs, the U.S. economy continues to show strength. After a brief scare in the first quarter, inflation appears to be back on a better path. While recent readings are encouraging, our forecasts see Core PCE inflation trending sideways around the high 2% range into 2025, which underlines the challenge of slowing the inflation rate to the Fed’s target.
Stable growth and sticky inflation alongside a firm but gradually normalizing labor market are consistent with the market narrative that policy rates are likely to remain higher for longer. Our base case view continues to be that the Fed will remain on hold for most, if not all, of this year. Monetary policy is highly data-dependent, and the data have shown that it is too soon for the Fed to start cutting.
If the economy were to weaken faster than expected, the more modest inflation trend we’ve seen recently would allow the Fed to cut rates if needed.
Growth outside the U.S. has improved and progress on inflation has allowed some central banks to begin to ease. However, the Fed will dictate, to varying degrees, what rate-cutting cycles will look like globally.
Higher-for-longer rates can be a support for markets if certain conditions hold. If inflation continues to slow gradually, markets will have less uncertainty about the Fed’s next move. If growth is good enough, cracks are less likely to appear in credit. Then markets can hold within predictable ranges while higher yields generate more attractive returns for investors.
The risk we worry about is the potential for “higher for longer” to become “higher until something breaks.” Valuations and credit quality are still the key factors driving our portfolio strategy.
In U.S. rates, we’ve been trading the range in 10-year Treasuries over recent months, between 4.25% and 4.75%. Recent data have likely shifted the range lower over the near term, to 4.00%– 4.50%, but rising fiscal concerns could present upside risks to yields. We are biased to add duration at this point in the cycle and will look for attractive risk/reward opportunities to do so if rates test the top end of our expected range.
Credit
Our outlook for credit is positive for the near term, but downside risks are more prevalent in lower-quality segments that have benefited from the ”Goldilocks” environment that’s driven spreads lower over the last eight months.
Broadly, we still see strength in underlying credit fundamentals, and supply/demand dynamics look more favorable now that we’ve made it through the largest wave of new issuance for the year.
With spread valuations stretched, our strategy is biased toward higher-quality credit and a focus on maximizing yield while reducing our portfolio’s sensitivity to broad market risk. We like the opportunities at the front end of the curve in financials, investment-grade emerging markets, and asset-backed securities.
This strategy allows our portfolios to benefit if credit continues to perform well. But if the broader economy weakens, our more defensive approach should hold up better and provide room to add credit back at more attractive prices.
Taxable portfolio positioning
Exposure | View | Strategy |
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Rates | ||
U.S. duration & curve |
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Global duration & curve |
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MBS/agencies |
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Credit | ||
Investment- grade corporates |
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High-yield corporates |
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Emerging markets |
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Structured products |
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Municipal bonds
Municipals continue to be better situated to offer higher tax-exempt income than they have been in the past decade. While some lower-rated sectors like higher education will still experience credit- related challenges, the vast proportion of the market exhibits strong fundamentals. With the Fed’s next move more clearly trending toward an interest rate cut rather than a hike, investors can allow themselves to be upbeat for the next 12 months in municipal debt.
We’ve been fielding questions on issuance, usually from clients hearing that fewer new muni bonds have been issued in 2024. It’s a nuanced subject that leaks into other aspects of muni investing.
Cumulative issuance in 2024 has, surprisingly, trended far higher through June 30 than it has in years. While a “normal” level of annual issuance in this market is ambiguous—various yield environments and tax changes over time have clouded averages—the amount of clearance above prior years’ levels is meaningful: 42% more issuance than this time last year, and 12% more than the previous high in 2015 (through June 30 of that year).
At the same time, municipal fund flows have been mostly positive all year. Our traders report that aggregate demand for new bonds has been fierce, with many new issues being many times oversubscribed.
One may think that this is leading to a natural balance, with heavy supply being met by healthy demand. However, these higher-level data obscure the fact that very little issuance has come from the middle rungs of municipal credit (A through BB rated bonds). BBBs, for instance, make up less than 6% of the Bloomberg Municipal Bond Index. In any given period, a strong supply of such credits is less than assured.
Funds are the primary buyers of middle- and lower-rated bonds in the municipal bond world. As a result, flows into these products have a strong influence on credit spreads. And with both long-term and high-yield funds focusing primarily on longer-maturity debt, demand for such products tends to have a meaningful effect on spreads on that segment of the curve. The effect is similar for short-term funds on spreads at the short end of the curve.
As mentioned last quarter, fund-buying has recently concentrated on long-term and high-yield municipal funds. While this general trend has been prevalent since the beginning of 2023, high-yield fund demand has been particularly strong year to date in 2024. Concurrently, shorter-term muni funds have experienced substantial outflows. This combination has led to meaningfully wider credit spreads, and thus greater opportunities, at the short end of the curve.
Meanwhile, among higher-rated munis, valuations at the short end of the curve continue to look very rich relative to Treasuries. As long as managers of SMAs, who tend not to focus on relative value, continue to buy securities in this segment of the market, there is little reason to expect that valuations will improve there.
Relative to Treasuries, tax-exempt yields would still favor the longer end of the yield curve for many higher-income investors.
Municipal issuers continue to exhibit strong balance sheets, bolstered by pandemic-era stimulus. While the excesses of that period are wearing away, prudent financial decision-making continues to benefit ratings activity. While downgrades have been subdued for some time, rating upgrades have been increasing and were especially strong in the fourth quarter of 2023. Our role as active managers is to move ahead of rating changes, but the aggregated data do show the ongoing strength of the sector.
Tax exempt portfolio positioning
Exposure | View | Strategy |
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Credit allocation |
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Structure |
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Duration/curve |
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Vanguard active bond funds and ETFs
Vanguard active bond funds and ETFs | Admiral™ Shares or ETF ticker symbol | Expense ratio1 |
---|---|---|
Treasury/ Agency | ||
GNMA2 | VFIJX | 0.11% |
Inflation-Protected Securities | VAIPX | 0.10 |
Intermediate-Term Treasury | VFIUX | 0.10 |
Long-Term Treasury | VUSUX | 0.10 |
Short-Term Federal | VSGDX | 0.10 |
Short-Term Treasury | VFIRX | 0.10 |
Investment-grade corporate | ||
Core Bond | VCOBX | 0.10% |
Core Bond ETF | VCRB | 0.10 |
Core-Plus Bond | VCPAX | 0.20 |
Core-Plus Bond ETF | VPLS | 0.20 |
Intermediate-Term Investment-Grade | VFIDX | 0.10 |
Long-Term Investment-Grade2 | VWETX | 0.11 |
Multi-Sector Income Bond | VMSAX | 0.30 |
Short-Term Investment-Grade | VFSUX | 0.10 |
Ultra-Short-Term Bond | VUSFX | 0.10 |
Ultra-Short Bond ETF | VUSB | 0.10 |
Below-investment-grade | ||
High-Yield Corporate2 | VWEAX | 0.12% |
Global / international | ||
Emerging Markets Bond | VEGBX | 0.40% |
Global Credit Bond | VGCAX | 0.25 |
Vanguard active municipal bond funds | Admiral™ Shares or ETF ticker symbol | Expense ratio1 |
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National municipal | ||
Ultra-Short-Term Tax-Exempt | VWSUX | 0.09% |
Limited-Term Tax-Exempt | VMLUX | 0.09 |
Intermediate-Term Tax-Exempt | VWIUX | 0.09 |
Long-Term Tax-Exempt | VWLUX | 0.09 |
High-Yield Tax-Exempt | VWALX | 0.09 |
State municipal | ||
California Intermediate-Term Tax-Exempt | VCADX | 0.09% |
California Long-Term Tax-Exempt | VCLAX | 0.09 |
Massachusetts Tax-Exempt3 | VMATX | 0.13 |
New Jersey Long-Term Tax-Exempt | VNJUX | 0.09 |
New York Long-Term Tax-Exempt | VNYUX | 0.09 |
Ohio Long-Term Tax-Exempt3 | VOHIX | 0.13 |
Pennsylvania Long-Term Tax-Exempt | VPALX | 0.09 |
Active fixed income team
Global Head of Fixed Income Group
At Vanguard since 2019
In industry since 1992
Sara Devereux is a principal and global head of 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.
Global Head of Credit
At Vanguard since 1990
In industry since 1990
Christopher Alwine is global head of Credit and Rates, 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.
Global Head of Rates
At Vanguard since 2022
In industry since 2000
In his role as global head of Rates, Roger Hallam oversees the Global Rates, Treasury, Mortgages and Volatility, Currency, and Money Market Teams. He is a member of the Vanguard Senior Leadership Team and the Senior Investor Team. Prior to joining Vanguard, Mr. Hallam had been at J.P.Morgan Asset Management for more than 20 years as a senior global fixed income portfolio manager, and more recently as chief investment officer for Currencies. Mr. Hallam served as chair of the Currency Investment Policy Committee and was a member of the Global Fixed Income, Currency, and Commodity Investment Quarterly strategy team. He earned a B.S. from the University of Warwick and is a CFA charterholder.
Head of U.S. Municipals
At Vanguard since 2005
In industry since 2005
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.
Senior Investment Specialist—Active
Dan Larkin joined Vanguard in 2016 as a senior product manager in Vanguard Portfolio Review Department, where he is responsible for supporting the active taxable fixed income product lineup, including: monitoring each fund’s positioning and performance in the markets, communicating about our products internally and externally, and driving and implementing product improvements.
Before joining Vanguard, Mr. Larkin was the director of fixed income for Nationwide Financial's Manager Research Team and was charged with the oversight and manager search efforts for all of Nationwide's sub-advised fixed income mutual fund strategies. Previously, he was a vice president at Barclays Capital responsible for the Mid-Atlantic business of Barclays portfolio management platform, POINT. There he worked with large institutional clients and was responsible for new business development, portfolio analysis, and relationship management. Prior to his time at Barclays, he was a mortgage-backed securities analyst at Standard & Poor's.
Mr. Larkin earned a B.B.A. in finance at James Madison University.
Senior Investment Specialist Active Fixed Income
Nate Earle is a senior active fixed income product manager at Vanguard, primarily focusing on the firm’s municipal bond franchise. Prior to joining the company, Mr. Earle came from State Street Global Advisors, where he served as a fixed income portfolio strategist. Prior to joining SSgA in 2017, he held similar roles in the fixed income product management organizations of both Standish and PIMCO. Mr. Earle earned a B.A. at Bates College and an M.B.A. from the Kellogg School of Management. He is a CFA charterholder and a certified FRM.
Note: Data as of June 30, 2024.
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1 As reported in each fund’s prospectus. A fund’s current expense ratio may be higher or lower than the figure shown.
2 Investment advisor: Wellington Management Company LLP.
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4 Includes funds advised by Wellington Management Company LLP.
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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. 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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