“When we consider the hurdles facing corporate issuers, and the potential volatility and dispersion they can create in credit markets, an active management approach with a focus on credit security selection is even more vital.”
Lead portfolio manager of the Vanguard Global Credit Bond Fund
As corporate bond investors face the growing likelihood of recession and the resulting volatility, the depth and breadth of the slowdown in growth will play a meaningful role in determining the trajectory of global credit markets.
While a soft landing would likely be the most favourable scenario for credit markets, the signs of weakening growth in most economies suggest such a benign outcome is increasingly unlikely. This is raising concerns about how an economic slowdown will affect the day-to-day operations of corporate bond issuers—and in turn, their creditworthiness—under tighter financial conditions.
For most of 2023, global credit markets have been pricing in a soft landing as both growth and inflation moderated from their cyclical highs. Yet as the economic climate continues to weaken, corporate bond performance is likely to be more sensitive to the impact that a slowdown will have on corporate fundamentals.
Here, Vanguard’s active credit team share their views on what they believe is the best approach to creating long-term value from active credit and how to prepare investor portfolios for what lies ahead.
An economic downturn can present a range of challenges for corporate bond issuers. Weaker demand, for example, can make it difficult for companies to pass along higher costs through price rises to their customers - putting pressure on margins and squeezing cash flows. For those with maturing debt, the shock of significantly higher refinancing costs in the current interest rate environment may add additional stress to corporate balance sheets.
For example, as recent slowing economic activity in Europe has started to impact sectors such as basic materials, industrials and consumer discretionary, this has opened up a number of attractive selection opportunities, particularly among European BBB-rated industrials issuers.
When we consider the hurdles facing corporate issuers, and the potential volatility and dispersion they can create in credit markets, an active management approach with a focus on credit security selection is even more vital.
By focusing on the fundamentals of individual issuers, conducting thorough credit analysis and building portfolios using diversified sources of alpha, active credit strategies with a bottom-up approach to security selection can help investors mitigate their exposure to broad market swings while capitalising on idiosyncratic return opportunities when they occur.
Some active credit funds take excessive bets on the direction of bond markets to generate returns, often referred to as a ‘levered beta’ approach. Yet strategies that rely on levered beta to generate excess returns, especially in more volatile environments, tend to have a low probability of success over the long term.
Rather than relying on top-down, directional or correlated risk positions to generate returns, investors should look for active credit managers that efficiently construct their portfolios to provide the best active returns relative to the risk incurred, with a focus on idiosyncratic opportunities that can help diversify risk regardless of market conditions.
Such opportunities do not just come from choosing the right issuers in each sector. They can also arise from selecting the right currency in which to gain exposure to a given issuer and the optimal point on the yield curve, as well as other considerations, such as weighing up the relative merits of senior versus subordinated bonds and whether to use cash or other instruments to implement positions. Opportunities are therefore plentiful - and not dependent on the direction of markets.
For investors, the impact of lower fees on long-term returns is well-established1. What is less well understood is how lower costs can play a role in an active credit fund’s investment strategy and performance.
Active funds with lower expense ratios like the Vanguard Global Credit Bond Fund have an asymmetric advantage: the fund's low fees and global scale mean its managers aren't under the same pressure to maintain a certain level of risk to offset their costs to investors. As a result, Vanguard's fund managers can be more opportunistic in their approach, holding back when markets look overvalued and taking positions when dislocations occur and opportunities arise.
When markets are volatile, investors in active credit may want to focus on fund managers with a ‘true-to-label’ track record - those which have consistently delivered alpha at an equivalent level of risk to their benchmark.
Importantly, funds that derive alpha from a diverse range of securities can be better equipped to deliver a more consistent stream of returns in all market environments. This contrasts with ‘levered beta’ strategies, which rely on taking correctly timed, directional bets on market movements to generate additional returns.
Funds like the Vanguard Global Credit Bond Fund can add a diversified layer of credit exposure to investors’ fixed income portfolios, with the aim of providing a more consistent level of risk-adjusted returns while avoiding additional risk when economic and market conditions are shifting.
The Vanguard Global Corporate Bond Fund was recently awarded the Gold Medalist Rating by Morningstar, based on its strong management team and risk-adjusted approach, backed by the consistency and reputation of Vanguard.
1 ‘The case for low-cost index-fund investing’, Vanguard research, May 2023.
Important 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.
Investments in smaller companies may be more volatile than investments in well-established blue chip companies.
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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