Active Fixed Income Perspectives: Q4 2021

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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.

Key highlights

Performance

There was little change in credit spreads or yields over an uneventful third quarter. The market narrative shifted as global economic growth slowed from a rapid pace, while high inflation readings and the definition of transitory continued to drive debate.

Looking ahead

Strong credit fundamentals and investor demand continue to pin yields near historical lows, but that also means risk assets are vulnerable to an economic or market shock. We believe that the reduction of monetary and fiscal support will be gradual and the path forward for policy appears clear. We expect interest rates to gradually track higher.

Approach

Valuations leave little room for the upside, but incrementally higher interest rates offer the potential for better forward-looking returns. Less policy accommodation leaves room for more market volatility and more opportunities to find attractively priced securities.

OVERVIEW

Inching toward normal

During the third quarter, yields initially dropped on signs of slowing global growth and fears over the spread of the Delta variant of the coronavirus. But yields popped up when inflation readings came in higher than expected and central banks globally took a more hawkish tone.

Developed markets' central banks are inching toward policy normalization by reducing their direct bond purchases. The Federal Reserve, likewise, has indicated it will begin tapering by the end of the year, expecting to wind down its $120 billion-per-month commitment by mid-2022.

A "Bunker Hill" strategy

The yield of the 10-year U.S. Treasury note more than doubled from the same time last year, providing a marginally better environment for future returns. Nonetheless, yields remain low and valuations across credit sectors are still expensive relative to history. That's because economic growth is strong and consumer and corporate credit fundamentals have improved.

Recent movements in Treasury yields and the pullback in equities offer signals of coming market volatility that could present attractive investment opportunities. Our approach is similar to the tactics of American commanders during the battle of Bunker Hill in the Revolutionary War. They ordered their soldiers to hold their fire until, according to the longtime story, they could see the "whites of the eyes" of the British troops, to ensure an accurate volley. Likewise, we've focused our efforts on the few reasonably priced areas of the market while awaiting better targets.

Taxable fixed income sector returns

Taxable fixed income sector returns

Sources: Bloomberg indexes and J.P. Morgan EMBI Global Diversified Index, as of September 30, 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.

RATES AND INFLATION

The Federal Reserve has tried to differentiate the act of asset tapering from that of raising interest rates. The next rate hike may be pulled into late 2022 rather than the prior consensus date of 2023. While we expect monetary policy to become gradually less supportive, we are still a long way away from it being restrictive.

A more important question is whether inflation metrics begin to fall back to long-term trends or stay elevated, forcing the Fed to act more quickly than planned. The U.S. Bureau of Economic Analysis's August reading of the core personal consumption expenditures (PCE) price index—the Fed's preferred inflation measure—was up 3.6% year over year, which is the highest rate of change in three decades.

A ceiling on inflation expectations

Supply shortages and setbacks in the reopening of COVID-impacted sectors have made short-term inflation dynamics volatile. We expect near-term inflation to remain elevated, potentially pushing higher, before reverting back toward trend. We see core PCE declining to around 2.5% by the end of next year.

Treasury Inflation-Protected Securities (TIPS) valuations remain rich and a reduction in policy accommodation puts a ceiling on how high inflation expectations can go.

Government rates: Year-over-year yield curve change

Government rates: Year-over-year yield curve change

Source: Bloomberg, data as of September 30, 2021.

Mortgage-backed securities

The agency MBS sector managed to cheapen a bit over the course of the quarter. Modestly wider spreads and higher Treasury yields were enough to bring marginal buyers back into the market. Relative to history, however, the sector remains expensive.

The Fed's plans to step back from its MBS purchases means the sector will gradually lose a large buyer of securities. While this plan has been well telegraphed, it still represents a headwind. That, combined with higher interest rate volatility and faster prepayment rates, keeps us cautious on MBS across our portfolios. In our view, security selection is the best strategy until valuations offer a better chance to add exposure.

Implications for Vanguard funds:

  • We expect interest rates to gradually track higher to go along with above-trend economic growth in 2021 and 2022. Economic resilience remains high, balance sheets are strong, financial conditions remain loose, and the labor market continues to recover.
  • We continue to analyze data to find evidence of sustained inflation pressures in the sectors and companies less affected by the COVID-19 pandemic. To date, we remain convinced that recent high inflation trends will prove temporary.
  • We have reduced our MBS positions and see TIPS as fairly valued. We are focused on security selection to add alpha.

CREDIT MARKETS

Expensive valuations have been justified given the backdrop of strong investor demand, improving fundamentals overall, a global search for yield, and easy financial market conditions. A shift toward tighter monetary policy has implications for credit sectors, but the degree and timing of the impact vary considerably.

We do expect more volatility over the coming months as investors turn their attention back toward the credit fundamentals of individual issuers, a healthy adjustment. Meanwhile, select high-yield corporates and emerging markets (EM) bonds provide more attractive yields and prospects for price appreciation.

Credit spreads remained flat over the quarter

(in basis points, from September 30, 2020, through September 30, 2021)

Credit spreads remained flat over the quarter

Sources: Bloomberg indexes and J.P. Morgan EMBI Global Diversified Index, as of September 30, 2021.

Investment-grade corporates

A tremendous amount of investor demand for high-quality yield has kept credit spreads stuck within a 20-basis-point range since the start of the year. Most companies overall have generated strong earnings, validating the rich valuations.

Companies have suffered from supply chain disruptions, but many have also shown strong pricing power and the ability to manage through unique challenges. If higher input costs continue to drag on production and negatively impact earnings, we would expect equities to bear the brunt and would not expect a dramatic repricing for corporate bonds.

Keep calm and "carry" on

Higher interest rates, and any modest widening in credit spreads, have been met with interest from global yield buyers, so we consider the sector well-supported.

We are positioned to take advantage of any spread widening to add exposure at better prices. With the sector fairly valued, performance in the coming months will come from carry with little room for price appreciation.

High-yield corporates

Strong credit fundamentals have also supported below-investment-grade corporate bonds. Investors looking for more yield and less exposure to rising interest rates have compressed high-yield bond valuations to the third percentile over the 10 years ended September 30, 2021. Annual defaults in the sector typically average around 3.5%, but in 2021 they have been running at or below 1.0%, which hasn't occurred since 2007.

Crossovers offer potential alpha

Potential price appreciation is limited, but the sector offers attractive carry in a yield-starved world. Rising-star bonds, poised to be upgraded to an investment-grade rating, are attractive investments, and some value remains in companies sensitive to the economic effects of COVID.

We estimate that $100 billion to $150 billion worth of outstanding debt has the potential to be upgraded, particularly in energy and commodities. In this opportunity set, the average bond that is upgraded captures 25 basis points or more of spread compression. We have found that bonds crossing from investment-grade to high-yield, and vice versa, offer better risk-adjusted returns.

Over time, crossovers tend to generate higher risk-adjusted returns than BBBs or high yield

Over time, crossovers tend to generate higher risk-adjusted returns than BBBs or high yield

Notes: The two-year risk-adjusted return was calculated by dividing the annualized two-year return by the 360-day standard deviation annualized over two years. Data are two-year averages from April 2006 through August 2021.

Sources: Vanguard calculations, based on data from Bloomberg.

Past performance is no guarantee of future returns.

Emerging markets

Several crosscurrents combined to produce a pickup in EM bond volatility. The month saw increased pressure from higher U.S. rates, increased EM high-yield supply, and outflows sparked by concerns over the Chinese property sector. The biggest repricing came in EM high yield, especially in frontier names—the part of the market we have become increasingly cautious on in the past several months. We also saw upward pressure on EM local interest rates.

But now, we are more constructive on the asset class than we have been in some time as segments of the market have repriced to better valuations.

Risks from China

We see pockets of value in parts of EM high yield, especially in longer-dated bonds where credit curves are steep and the bonds offer positive convexity.

However, market conditions warrant a cautious approach overall in EM as we look ahead. A slower growth trajectory in China and the risks there of an energy crisis are key risk factors that we’ll be watching given their close linkage to economic growth in other developing countries.

Structured products

Asset-backed securities (ABS) issuance volumes trended higher over the last few months, and secondary-market trading activity has picked back up from the summer doldrums. Spreads have remained near historic lows, supported by investor demand. The high-quality sector continues to offer attractive yield above government bonds.

Commercial mortgage-backed securities (CMBS) have been far slower to resume their pre-COVID issuance pace, but the sector is on a path to further recovery. While inflation can present challenges to other sectors, higher property prices enable property owners to charge higher rents, providing more support to CMBS bonds.

Implications for Vanguard funds:


  • High-yield corporates offer some potential alpha, but spreads overall are historically tight.
  • EM bonds offer strong potential, but we are watching out for slowing growth in China and how that could affect growth in other developing countries.

MUNICIPAL BONDS

Municipal yields

We still see muni rates gradually moving higher, but the path will be governed by movements in the 10-year Treasury's yield. Economic growth, inflation readings, and financial-market conditions will continue to drive our rates outlook. We do not see muni rates dislocating from those of Treasuries in the coming months. The strong pace of flows into the sector have slowed just a bit. As yield levels improve, additional demand from investors with healthy cash balances should help keep muni yields in check.

Municipal credit

An additional headwind to recent performance has been the relative weakness in municipal credit. Spreads widened in the third quarter, ending a long period of outperformance for lower-quality segments of the market. We view this minor correction as a healthy reset rather than an indication of future performance. Investor demand remains for tax-exempt securities that offer reasonable yield. We welcome the chance to add exposure to securities we like at better price points.

We see value in maintaining a modest overweight exposure to mid-quality, investment-grade muni credit across our portfolios. While price appreciation is unlikely to drive excess returns, more exposure to credit improves portfolio yield and is justified by our favorable views on fundamentals. Tax receipts have improved, and the fiscal health of the market is on strong footing. We are more cautious on lower-quality securities that have become too expensive. We continue to assess the longer-term trajectory of issuers awash in stimulus funding. How that money is spent and what amount is recurring will influence our credit opinions and portfolio positioning as those benefits fade.

Muni/Treasury ratio
 2 Years 5 Years 10 Years 20 Years  30 Years
U.S. Treasury Yield 0.28% 0.97% 1.49% 1.99% 2.05%
Municiple Market Data AAA Curve  0.16% 0.52%  1.12%  1.46%  1.67%
Ratio  0.59% 0.54%  0.75%  0.73%  0.82%

Sources: Vanguard and Bloomberg, as of September 30, 2021.

Implications for Vanguard funds:

  • Rates have the momentum to increase further, but that shouldn't disrupt the market. Higher yields will benefit investors over the longer term.
  • The range of opportunities in credit have narrowed, but our fundamental view supports an overweight to segments that offer better incremental yields.
  • Progress toward an infrastructure package has stalled of late. If passed, it is likely to produce higher issuance over time, which the market should be able to digest.

VANGUARD ACTIVE BOND FUNDS OR ETFS

  Admiral Shares or ETF ticker symbol Expense Ratio
 TREASURY/AGENCY    
GNMA 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-Plus Bond VCPAX 0.20%
Intermediate-Term Investment-Grade VFIDX 0.10%
Long-Term Investment-Grade VWETX 0.12%
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 Corporate VWEAX 0.13%
GLOBAL/INTERNATIONAL
Emerging Markets Bond VEGBX 0.45%
Global Credit Bond VGCAX 0.25%
Vanguard active municipal bond funds
NATIONAL MUNICIPAL
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-Exempt 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-Exempt VOHIX 0.13%
Pennsylvania Long-Term Tax-Exempt VPALX 0.09%

Our active fixed income lineup

Find out how our active fixed income funds aim to be true-to-label and provide strong risk-adjusted returns.

View Our Lineup

Active fixed income research team
Sara Devereux
Global Head of Fixed Income Group
Christopher Alwine, CFA
Global Head of Credit and Rates
Paul Malloy, CFA
Head of Municipals
Dan Larkin
Senior Fixed Income Specialist
Active fixed income leadership team
Sara Devereux
Global Head of Fixed Income Group
Christopher Alwine, CFA
Global Head of Credit and Rates
Joe Davis
Vanguard Global Chief Economist
Paul Malloy, CFA
Head of Municipals
Manish Nagar
Global Head of Risk Management Group

Active fixed income at Vanguard

Active Fixed Income at Vanguard

*Includes funds advised by Wellington Management Company LLP.

Note: As of September 30, 2021.

Notes:

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 about a fund 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 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.
  • Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • CFA® is a registered trademark owned by CFA Institute.

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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.

  3. Investor Shares available only. There is no minimum investment required for advised clients.