Active Fixed Income Perspectives: Q4 2021

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.

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

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

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.

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)

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

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.

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.

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

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Note: As of September 30, 2021.

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