By Kelly Gemmell, investment product manager, Vanguard Europe
With inflation rising and central banks tightening monetary policy, some investors might be concerned about what this means for the active fixed income holdings in their portfolios.
Even before Russia’s invasion of Ukraine triggered a surge in energy prices, policymakers had already embarked on the path towards tighter monetary policy. Now, as higher commodity prices threaten to weigh on growth and generate higher inflation more broadly, markets are pricing in more interest-rate hikes than they expected just six months ago.
This is reflected in the level of government bond yield curves, which have risen significantly – particularly in the “belly” of the curve, which represents the yields on intermediate-maturity bonds. For instance, the US Treasury yield curve, shown below, looked radically different in April than it did last September.
US Treasury yield curve – September 2021 and April 2022
Source: Bloomberg, as at 11 April 2022.
Credit spreads have also widened, indicating a deterioration in earnings expectations. This is particularly the case for credits which are more negatively impacted by the rising price of oil, such as airlines.
In such an environment, investors would do well to remember what they seek in fixed income, as the role of bonds as the bedrock of stability in a portfolio is arguably even more crucial at times of heightened uncertainty. As rates rise, high-quality bonds remain a source of income, liquidity, diversification from riskier assets and potential capital return.
And for credit, the combination of a rising risk-free rate (the yield on developed market government bonds) and widening credit spreads has caused the nominal yield (that is, the yield before adjusting for the impact of inflation) on credit bonds to increase. This can help to reduce the corrosive impact of inflation, cushion the impact of rising rates over time and also contribute to reducing drawdowns.
For active fixed income strategies, rising rates and increased volatility can pose risks – but also open up new opportunities.
In fast-changing, volatile markets, active strategies that focus primarily on making tactical directional bets in an attempt to generate returns can suffer significant drawdowns if their beta bets turn sour. They can also cause confusion around where the returns of active bond funds should come from – in our view, these should derive from alpha, not beta.
On the other hand, by focusing on deriving alpha from genuine security selection across diversified sources, without taking excessive top-down directional risk1, investors can get the best from the asset class while lowering the risk of large drawdown losses. This can be one of the most effective ways to add value from actively managed fixed income portfolios in any market environment – but it is especially valuable as investors seek to navigate more challenging market conditions.
Within the global credit universe, there is a rich opportunity set in which to generate alpha for investors. Heightened volatility, rising inflation and higher funding costs for issuers are leading to greater dislocations between improving and deteriorating credits.
For example, Vanguard’s credit research analysts have been analysing which companies are better equipped to pass on rising input costs to their customers in order to protect their margins. This is where analyst due diligence becomes particularly important. By considering the specific situation in each sector and company, our analysts can look beyond the obvious beneficiaries—such as oil companies—and unearth other credits with the potential to pass on costs.
The automotive industry, for instance, is cyclical, and volumes and prices can be challenged when consumer incomes are squeezed and growth slows; however, supply bottlenecks have translated into strong pricing, which has bolstered earnings. Here, analysis of how these conditions affect each company—and whether or not that is reflected in the price—is critical to the investment decision.
Within emerging market bonds, where certain risk factors can also become exacerbated by market volatility, a focus on security selection and relative value is equally important. Aiming to generate consistent alpha while preserving the risk and asset-class profile of the asset class and staying mindful of crowded trades, tail-risk scenarios and beta exposure are all crucial.
Markets have also recently priced in a significant amount of “bad news” into emerging debt markets, thus making valuations more attractive and opening up new opportunities.
At Vanguard, we believe our active fixed income funds are well placed to help investors navigate the current uncertainty in bond markets.
1 Source: Morningstar, Bloomberg and Vanguard from 30 September 2018 to 15 January 2021. The percentage of active risk explained by credit beta (rolling one-year) for the Vanguard Global Credit Bond Fund was consistently lower than that of its peer group average from 30 September 2018 to 15 January 2021. Peer group defined by Morningstar - EAA OE Global Corporate Bond - USD Hedged.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.
Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.
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