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.
Investors ratcheted credit spreads even tighter over the three months ended June 30, 2021. Interest rates pulled back from recent highs and bond returns were positive, but some bond market yields reached near-historic lows.
We are watching for signs of sustained inflation, such as higher wages and a faster velocity of money. But demographics, technology, and a flexible Federal Reserve should ultimately keep inflation, and interest rates, under control.
We have lightened up on credit risk, collected excess return where we could, and otherwise stored proverbial dry powder. Broad-based opportunities targeting specific sectors, business models, or credit quality have largely dissipated. Outperformance for now will likely come from security selection.
Where do we go from here?
For many advisors and market professionals, the question remains, Where do we go from here? There have been enormous sums of money stacked up in the short end of the yield curve as many investors have been positioned to avoid the negative price impact of a large move higher in interest rates. Others have gone searching for yield in more obscure assets. We see neither of these, in the extreme, as the solution to a difficult market. Instead we prefer to be patiently opportunistic using a diversified set of strategies to add value.
Bond prices rose in the second quarter as the Federal Reserve turned more hawkish. Investors reasoned that the Fed would keep inflation reined in, putting downward pressure on yields. Credit responded well and spreads continued to narrow. While inflation remains a significant risk, it is hard to envision a scenario in which it runs unchecked by the Fed.
Value in duration
Bond yields continue to be persistently low and credit spreads are at or near historically tight levels. Nonetheless, there are fundamental reasons for current bond prices, and the market has factored in a reasonable path for rates.
Future returns may be more muted than in decades past, but in the near term, fixed income should generate positive returns with support from an improving global economy, accommodative fiscal and monetary policy, and favorable supply and demand. There is value in owning some duration exposure. As of June 30, the U.S. Treasury yield curve was steeper than it was a year prior, offering some term premium in higher-quality fixed income sectors. Our team takes some solace in that as we await better circumstances.
Taxable fixed income sector returns
Rates and inflation
A hawkish turn
The Federal Open Market Committee (FOMC) surprised the market in June, when it reacted more hawkishly to incoming data. This effectively took the scenario of an inflation overshoot off the table. The market reacted accordingly by pricing rate hikes sooner and reduced term and inflation premia in the long end of the curve. In response, the yield curve flattened as the yield on the 10-year Treasury dove below 1.3% in early July.
In addition, strong technical factors came into play that exacerbated the move lower in yields. Low summer supply was outstripped by bond-buying at the longer end of the yield curve by banks and international investors.
Rising rates over time
We view rates as relatively range-bound in the near term, with some room to move gradually higher as the economy continues to recover and the Federal Reserve tapers purchases. Internationally, developed markets’ central banks are facing similar price pressures. In Europe, inflation is expected to fall back well below central bank targets likely keeping the European Central Bank’s monetary policy accommodative for an extended period.
The market had doubted the ability of the Fed to create inflation, and what we’ve seen is the Fed has the ability to be patient. We expect more guidance on the future tapering of asset purchases either at the Jackson Hole Economic Policy Symposium in August or at the September FOMC meeting.
Government rates: Second-quarter yield change by maturity (in basis points)
Greater supply of mortgage-backed securities (MBS) and reduced demand pushed spreads wider over the quarter. Although the sector was still able to generate a positive total return as interest rates declined, MBS underperformed similar-duration Treasuries. Mortgage borrowing costs remain low by historical standards, and housing activity is robust.
Net supply of MBS has increased significantly with over $400 billion coming in the first half of 2021 and estimates of $300 billion more expected over the second half of the year. The sector has been supported by the Fed's MBS purchases as well as demand, particularly from banks and international investors.
The Fed's hawkish turn in June was felt by the MBS market. Valuations cheapened slightly, but spreads are still historically tight. Higher-than-expected levels of interest rate volatility have been a headwind. When the Fed starts to taper, and as bank purchases start to slow, we expect MBS to underperform.
Relative to this time last year, the opportunities in the MBS market are less broad-based. We've reduced our exposure, but we still see value and diversification benefits in those parts of the market that offer relatively attractive yield with protection against prepayments.
Implications for Vanguard funds:
- Maintaining duration exposure has proved valuable. We continue to seek out tactical rates opportunities along the yield curve.
- The market's move to lower rates in early July was surprising. Over time we see yields moving gradually higher.
- We remain underweight in MBS even as we seek to add value through selection in the sector.
Peak liquidity behind us
The outperformance of lower-quality bonds has been notable, driven mainly by investors seeking positive real returns in an economic recovery. The ability for this trend to persist is unlikely in our view.
While the pace of spread tightening slowed, credit sectors across the board were resilient in the face of the Fed's comments and generated positive excess returns over the quarter. The appetite for yield has continued to push those investors seeking higher returns further out on the risk spectrum.
Peak global liquidity and central bank support are likely behind us, which will also create a stronger headwind for lower-quality bonds.
We are constructive on credit, but many of the highest-quality names are priced too rich and lower-quality names are vulnerable to a change in sentiment. We've reduced our credit exposure, and we are focused on improving credit stories that have upside potential. Compared with roughly a year ago, overweights to specific sectors, business models, or credit-quality buckets offer little value in today's market.
Going forward, economic data and the Fed's reaction will drive markets. Yet we expect credit to remain well supported with substantial demand from a global investor base. Expensive valuations make us more cautious, and we hold ample liquidity to add exposure if prices adjust.
Credit spreads traded in a tight range over the quarter, after a dramatic compression last year
In basis points (bps), from June 30, 2020, through June 30, 2021
High-quality corporate bonds, as measured by the Bloomberg Barclays U.S. Corporate Bond Index (+3.55%), rebounded last quarter, which helped to offset their first-quarter performance (–4.65%). The sector benefited from the decline in Treasury rates at the intermediate- and long-end of the curve and from spread tightening.
Corporates advanced during the first-quarter earnings reporting season, as a higher-than-average number of companies outpaced expectations and economic activity improved across industries. Our favorable allocations to cyclical sectors and lower-credit-quality investment-grade issuers provided a performance boost to our portfolios. But today most of the investment-grade sector is trading at historically expensive valuations, which leaves fewer opportunities for high-conviction bets.
Potential sources of outperformance
We expect to see a continuation of the record pace of share buybacks funded with debt as well as elevated merger and acquisition activity, both of which should result in new supply and potentially better investment opportunities later this year. As corporate fundamentals continue to improve, our investment-grade and high-yield teams are focused on identifying the best opportunities in "rising star" issuers poised to get upgraded by rating agencies to an investment-grade rating.
A record pace of issuance (more than $280 billion) through the first half of the year has not prevented spread levels on below-investment-grade issuers from continuing to narrow. That has occurred partly because most of the issuance was used for debt refinancing, so the net supply is in line with historical levels.
Little incentive in lower-quality bonds
The yield on CCC rated debt fell to 5.60%, its lowest level on record. The differential between below-investment-grade debt and investment-grade debt also continued to shrink, to 184 basis points, the lowest level since July 2007. Investors are simply not getting paid appropriately to go down in quality.
We see the best opportunities in a barbell approach to the sector. We are focused on rising stars and on COVID-19-affected companies that should benefit from the economic reopening, such as travel and leisure.
Emerging markets (EM) debt outpaced the other major bond market sectors in the second quarter, as the J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified produced a return of 4.06%, which helped to bring the asset class closer to even (–0.6%) for the six months. The decline in longer-maturity U.S. Treasury rates drove most of the performance, but credit spreads also managed to narrow by 14 basis points.
Nonetheless, while spreads remain compressed across the globe, EM debt is one place where there remains some relative yield, and increases in commodity prices can help. Lower-quality EM continued to outperform. Ecuador has been the strongest of the group so far this year because of low near-term financing needs, higher energy prices, and a new administration that has made progress toward fiscal reform. Our overweight to Ecuador has benefited our portfolios.
Pockets of value
Investment-grade EM debt was held back over the quarter by political events in higher-quality Latin American countries, most notably Chile, Colombia, and Peru. We've maintained an underweight to expensive, higher-quality countries, and this recent volatility has reinforced our view that investment-grade spreads leave little room for any unexpected credit deterioration. The EM market offers several pockets of value. A selective approach in lower quality is important, but its recent underperformance offers opportunities to add exposure to names we like.
Over the last few months, we've seen EM central banks turn more hawkish in the face of rising inflation. Brazil and Russia were among the first to raise policy rates to fight off increasing price pressures, and each increased rates during the quarter. Mexico surprised the market with a 25-basis-point hike, and Hungary and the Czech Republic became the first European Union countries to raise rates this cycle. We will take advantage of opportunities in EM rates in markets with steep curves or where the market appears to have priced in overly aggressive central bank policy.
The new-issue market for asset-backed securities continues to be well oversubscribed by investors. Credit spreads for consumer-backed debt have been pushed below pre-global-financial-crisis levels by a good margin, highlighting just how expensive valuations are in the market today. On the positive side, consumers have put stimulus and savings to good use by continuing to pay off debt.
Spreads have continued to narrow for commercial mortgage-backed securities (CMBS), and we believe there’s room for further compression. The reopening of the broader economy should translate into lower delinquency rates and continued upside for issuers who were most negatively affected by the pandemic-induced shutdown.
While U.S. consumers remain financially strong, we are keeping a close eye on the health of the commercial property subsectors as the economic recovery intersects with new attitudes toward remote working. Creditworthiness within CMBS will depend on what the new normal looks like.
Implications for Vanguard funds:
- Rising commodity prices and wider credit spreads make EM one of the few areas in which to more broadly find attractive returns. Opportunities to add value persist, but we are mindful that EM central banks have much less flexibility to support a recovery.
- The upside is limited among high-yield and investment-grade corporate bonds, but fundamentals are strong and yields relative to Treasuries are attractive. Performance in those sectors will be driven by individual security selection.
- We remain cautiously constructive on CMBS. Harder-hit segments, like office, hotel, and retail properties, continue to recover.
A steeper curve to come
In a similar pattern to Treasuries, the muni yield curve flattened over the quarter. Short-maturity yields inched higher while yields further along the curve declined, falling more than 20 basis points at the long end. The pullback represented a reversal of the sharp rise in rates experienced earlier this year and helped to boost returns for the quarter. Looking forward, we see a gradual path toward modestly higher muni rates and a steeper curve overall as economic activity returns to full strength.
The ratio of muni yields to Treasuries is less attractive by historical standards, but much could be said about many of the traditional measures of "rich versus cheap" for all asset classes in today's market. For munis, remember that the ratio compares a AAA rated 5% coupon muni bond against its comparable-maturity Treasury. In reality, those securities represent less than 10% of the broader municipal bond market. Investors in a diversified muni bond fund naturally gain exposure to a broader spectrum of credit quality, which makes the muni/Treasury ratio an important, but conservative, metric.
Infrastructure shouldn't disrupt the market
Progress toward some form of U.S. infrastructure legislation may continue to crowd headlines over the summer, but much still needs to be determined. The most recent Bipartisan Infrastructure Framework proposal identifies $579 billion of new spending that would target transportation and other traditional infrastructure areas. Many sources of funding have been proposed, but there has been little detail offered on what path they might take and what other concurrent, and less traditional, infrastructure proposals may be presented alongside them.
If additional tax-exempt supply were to result from any approved legislation, investor demand would likely absorb it. If revenue from higher personal and/or corporate tax rates were part of the plan to help pay for the projects, demand for munis would likely increase on the margin. Therefore, we don't foresee large market disruptions from what's currently been proposed, but we expect to gain more clarity over the coming months.
|2 Years||5 Years||10 Years||20 Years||30 Years|
|U.S. Treasury Yield||0.25%||0.89%||1.47%||2.02%||2.09%|
|Municiple Market Data AAA Curve||0.16%||0.49%||0.99%||1.32%||1.50%|
Sources: Vanguard and Bloomberg, as of June 30, 2021.
Municipal credit is well supported
As we highlighted last quarter, the stimulus funds provided by the COVID-19 relief bill and the American Rescue Plan Act undergirded municipal credit fundamentals. Longer-term fiscal reforms remain important for certain issuers, but over the near term, we are constructive on credit across most market segments.
The support for credit helped fuel the ongoing reach for yield and the outperformance of both lower-quality and longer-maturity segments of the market over the quarter. Credit spreads continued to compress and are now at or below their pre-pandemic levels.
Over the last several months, we benefited from attractive opportunities in lower-quality credit that had yet to fully recover. As that segment has continued to outperform, we've pared down exposures for which our assessment of the upside is now more limited.
While we believe credit is well-supported, rich valuations mean that the key performance drivers over the next few months will be issuer and security selection.
Implications for Vanguard funds:
- A material increase in muni rates is unlikely, but we are positioned for higher rates and a steeper curve.
- We are constructive on credit but believe spreads dictate a conservative approach. We hold ample liquidity in the hope of better opportunities to add risk.
Vanguard active bond funds or ETFs
|Admiral Shares or ETF ticker symbol||Expense Ratio1|
|Ultra-Short Bond ETF||VUSB||0.10%|
|Emerging Markets Bond||VEGBX||0.45%|
|Global Credit Bond||VGCAX||0.25%|
|Vanguard active municipal bond funds|
|California Intermediate-Term Tax-Exempt||VCADX||0.09%|
|California Long-Term Tax-Exempt||VCLAX||0.09%|
|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%|
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.
3 Investor Shares available only. There is no minimum investment required for advised clients.
Active fixed income at Vanguard
Taxable bond AUM
Municipal bond AUM
5 national funds/7 state-specific funds
Credit Research Analysts
Dedicated team members
*Includes funds advised by Wellington Management Company LLP.
Note: As of June 30, 2021.
- For more information about Vanguard funds or Vanguard ETFs, obtain a prospectus (or a summary prospectus, if available) or call 800-523-1036 to request one. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
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- Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.
- 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.
- Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
- Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
- Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
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