March 24, 2023
Although Vanguard is well known for its bond index funds, it also happens to be the largest provider of U.S. active bond funds.1 With all the recent headlines about bank failures, we asked Sara Devereux, global head of Vanguard Fixed Income Group, for her perspective on what happened with the banks, how our 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 Lehman Brothers subject to 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, realizing losses after their bond investments were 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 federal agencies and other banks.
We work closely with the 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 U.S., later this year.
Devereux: The portfolios actively managed by Vanguard’s fixed income team had minimal exposure to those banks. Our team did a great job in risk management and security selection. There was a market sentiment earlier this year that we would have a soft landing or perhaps no slowdown at all, encouraging more risk-taking. 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 happen. But we’re prepared to weather any storm.
Devereux: We’re defensively positioned. We have the liquidity to take advantage of opportunities as they come up. We call periods of extended uncertainty “Vanguard weather,” because they favor 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 defensive approach. We can do this because of our low fees. Competitors may feel pressure to maintain higher risk to offset higher fees. We can be opportunistic when others cannot afford to do so. In other words, we tend to do just as well as competitors in the good times but better in the bad times.
We may still have considerable market volatility in the months ahead of us. As evidenced by the Federal Reserve’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 central banks.
One of the positives with all the rate hikes 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, non-bank money market funds have seen remarkable flows in recent weeks, with the largest flows into government money market funds. Part of that is because of a flight to quality after the scare with bank closures, but it’s also because yields for money markets are currently very attractive.
Yields are also up for all 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 such as U.S. Treasuries, agency mortgage-backed securities, and municipals. 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 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 AUM for 1940 Act actively managed mutual funds, both taxable and municipal bonds, according to Morningstar data as of December 31, 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.
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