“Our asymmetric advantage over our peers allows us to be opportunistic when others cannot afford to do so.”
Global head of Vanguard Fixed Income Group
Although Vanguard is well known for its fixed income index funds, it is also the largest global provider of US active bond funds1. Following recent headlines about bank failures, we asked Sara Devereux, global head of Vanguard Fixed Income Group, for her perspective on what happened with these banks, how Vanguard’s bond portfolios fared in the market tumult that followed and how well positioned those portfolios are for future volatility.
Devereux: There are key differences from 2008. This isn’t like the collapse of Lehman Brothers, which involved counterparty risk in complex derivatives during the subprime mortgage crisis. The banks in recent headlines had risk management issues with traditional assets. Rapidly rising rates exposed those weaknesses. The banks were forced to become sellers, realising losses after their bond investments had fallen well below face value.
They might still be standing today if they hadn’t lost the confidence of their clients. It was more of a “sentiment contagion” rather than the true systemic contagion we saw during the global financial crisis. Vanguard economists believe that the damage has been largely contained, thanks to the quick action of central banks and government agencies.
We work closely with Vanguard’s economics team, and the incidents reaffirmed its base-case scenario of eventual disinflation but at a cost of a mild recession across developed markets, including the US, later this year.
Devereux: The portfolios actively managed by Vanguard’s fixed income team had minimal exposure to those banks and our UCITS fund range did not have any AT1 exposure2. Our team did a great job in risk management and security selection.
There was a market sentiment earlier this year that the economy would experience a soft landing or perhaps no slowdown at all, encouraging more risk-taking by some market participants. We did not fall for that narrative and kept our conviction that a recession was still a very real possibility.
We’re not saying that a recession will definitely happen. But we’re prepared to weather any storm and impacts on security selection.
Devereux: We’re defensively positioned. We have the liquidity to take advantage of opportunities as they come up. Periods of extended uncertainty favour our philosophy, our disciplined risk management and our active edge.
Our modest expense ratio gives us an asymmetric advantage. When the opportunity set is attractive, we can take the same amount of risk as our peers. But when the risk-reward outlook looks less attractive—for example, when expected returns are not high enough to compensate investors for risks on the horizon, such as a recession—we can reduce risk and take a more defensive approach. We can do this because of our low fees. Competitors may feel pressure to maintain higher risk to offset their higher fees. We can be opportunistic when others cannot afford to do so. In other words, our aim is to do just as well as competitors in the good times but better in the bad times. We believe the performance of our UCITS active fixed income bond funds demonstrate this.
We may still have considerable market volatility in the months ahead of us. As evidenced by the US Federal Reserve’s (Fed’s) latest rate hike, its fight against inflation isn’t over. But we’re getting closer to the end of the rate hike cycle by major central banks.
One of the positives to come from all the rate hikes we’ve seen over the past year is that the Fed now has room to ease interest rates if needed - an option it didn’t have when rates were near zero.
Devereux: Federal agencies have been working behind the scenes to help certain banks shore up reserves, further containing any contagion. Meanwhile, short-term fixed income has seen remarkable flows in recent weeks, with significant flows into money market funds globally. Part of that is because of a flight to quality after the scare with bank closures, but it’s also because yields for short-term bonds are currently very attractive.
Yields are up across all of fixed income, raising expected returns going forward. For investors who might have shied away from bonds because of their performance in 2022 or because of the years of low yields before that, it may be an opportune time to consider adding bonds to portfolios. Bonds are a strong diversifier to equity risk over the long term. Currently, you can lock in attractive yields as well.
Bonds tend to rally during a recession, and a recession is our base-case forecast. We recommend a defensive approach, focused on high-quality fixed income. For credit sectors, there is a lot of yield to be had in corporate credit. But with a recession likely on the horizon, it is critical to choose the right credit names. That is what our active teams do exceptionally well.
We’ve experienced times like these before, and we’ll likely experience them in the future. Our disciplined approach to portfolio management enables us to focus on the long term while weathering market swings.
1 Based on global AUM for US actively managed mutual funds, both taxable and municipal bonds, according to Morningstar data as at 31 December 2022. A few Vanguard bond funds or portions of bond portfolios are advised by Wellington Management Company. Commentary on portfolios here pertains to those managed by Vanguard Fixed Income Group.
2 AT1 is an acronym for Additional Tier 1 capital. It was introduced with Basel III after the Great Financial Crisis to replace the former term ‘Tier 1 Securities’ term. AT1 notes are a key instrument in regulators’ post-crisis bail-in regime and fulfil an important part of banks’ regulatory capital requirements. ‘UCITS’, or Undertakings for the Collective Investment in Transferable Securities, is the regulatory framework for European funds.
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.
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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