By Chris Alwine, Head of Global Credit, Vanguard
Since central banks first started to employ bold liquidity programmes and ultra-loose interest rate policy to lift the global economy out of the worst economic slump since the Great Depression, bond markets have benefitted spectacularly. In the 12 years from 1 January 2009 to 1 January 2021, the benchmark 10-year US Treasury bond1 returned an impressive 62.68% total return (4.13% annualised). But if you look at the 25-year issue2, which is geared more highly into the expectation of lower-for-longer interest rates, that return soars to 92.78% total (5.62% annualised).
This extraordinary rally has nevertheless delivered mixed blessings. While capital returns have been energised by it, income has been decimated as sovereign yields plunged3. As yields have fallen, we have seen investors diversifying away from government bonds and into corporate credit as they seek additional returns while retaining some diversification benefits from equities.
This year has started to see a turn in the cycle for bonds as investors sense that the curtain is about to fall on this benign backdrop. The greatest worry is that central banks will begin to remove monetary support, both in terms of low interest rates and financial asset purchase programmes, as nascent reflationary trends become more entrenched.
Reflation can be defined as inflation rising in tandem with economic growth. As a consequence of huge financial stimulus in the US, a strong recovery in economic activity in China and other emerging markets and accelerating output in Europe and Japan, we are seeing a strong build-up of inflationary pressure. One market measure of inflation expectations, the 5-year US break-even rate, hit 2.5% on 3 March 2021 for the first time since 20084. If this persists, central banks may feel obliged to respond.
Our view at Vanguard is that bond investors, particularly in the corporate space, should not fear reflation. It is, after all, a healthy sign that growth is gathering momentum. Eventually the global economy will have to stand unaided and that moment should be welcomed.
Before then, there is the distraction of a potential temporary surge in inflation to negotiate, this summer, as people get back to work and play following the pandemic.
Back to the medium term, we may well have to factor in much lower total returns than we have been used to in recent years, although a reflationary backdrop does open up significant potential for active investors, such as Vanguard. Reflation is a phenomenon that increases volatility and, with it, presents a greater opportunity set through a wider dispersion of returns across sectors. Add into the mix the ongoing uncertainty over the pandemic outcome and there is currently considerable scope for informed investors to add value.
Successful active bond investors benefit from a strong research capability that can identify inefficiencies and idiosyncratic opportunities, including those in the more specialist segments such as emerging market debt and high-yield bonds. Here, expert knowledge and a clear appreciation of where true risk lies can unlock superior rewards. This is when it is an advantage to have a large and talented team, and our Fixed Income Group is one of largest in the industry with around 180 professionals, with the overwhelming majority holding an MBA or being CFA charterholders, or both5.
In the quest for maximising returns in this brave new world, charging low fees can make all the difference. Lower fees can not only translate into a more attractive bottom line for investors, they also reduce the pressure on investment teams to take unnecessary and unattractive risk in pursuit of performance. Vanguard’s scale—we have $559 billion of actively managed fixed income assets6—and unique client-owned structure in the US, allow us to offer lower fees and this helps clients to take home more of their returns.
While we don’t envisage any meaningful shift in major central banks’ policy immediately, if and when it becomes clear the liquidity taps are being turned off, investors will be willing to pay a premium for assets that can shore up a diversified portfolio. We believe exposure to actively managed corporate credit is well suited to play such a role.
Scale, experience and specialism has always informed strong security selection and stood Vanguard’s active fixed income capability in good stead. These qualities will take on yet greater significance as we enter a new phase in the market.
Hear from Chris and other active investment experts at our Active Investor Conference this month. For more details, click here.
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1 Due to the rollover of securities we have used the Bloomberg Barclays US Treasury 7-10 year maturity index: 2nd Jan 2009 – 4th Jan 2021 as a proxy for the 10 year US Treasury return.
2 Due to the rollover of securities we have used the Bloomberg Barclays US Treasury 20+ year maturity index 2nd Jan 2009 – 4th Jan 2021 as a proxy for the 25-year US Treasury return.
3 On 2 January 2009 the 10-year US Treasury yield was 2.46% on 4 January 2021 it was 0.93%. Source: The U.S. Department of the Treasury, data as at 20 April 2021.
4 Source: Financial Times, 4 March 2021. Powell inflation comments send US stocks and bonds lower | Financial Times (ft.com)
5 Source: Vanguard, correct at 31 December 2020.
6 Source: Vanguard, correct at 31 March 2020.