"Amid the burgeoning dislocation we are observing in credit markets, taking a bottom-up approach to security selection in managing active credit has a distinct advantage."
Head of fixed income specialist team, Vanguard Europe
After the bond market gyrations of 2022, investor demand for duration—particularly for high-quality credit bonds—is making a comeback. Income is one driver of this resurgence in interest - the average yield on global investment-grade credit bonds, at over 5.0%, has far surpassed the dividend yields available on most equity markets1, as the chart below shows. For example, dividends on European and emerging market equities are both currently below 3.5%, while those paid by US S&P 500 companies average less than 1.8%2.
Global credit yields surpass equity dividend yields
Source: Bloomberg, data from 31 December 2012 to 28 February 2023. Indices used for equity dividend yields: S&P 500 Index; STOXX Europe 600 Price Index EUR; MSCI Emerging Markets Index. Index used for global credit yield-to-worst: Bloomberg Global Aggregate Credit Index.
However, despite the rosier outlook for the asset class, it’s important to be mindful of the threats facing investors in active credit funds that could threaten returns if not navigated correctly.
So far in 2023, the narrative driving credit markets has been fast-changing. At the beginning of the year, the big themes of 2022—namely high inflation and rising interest rates—morphed into concerns around slowing growth and rising credit risk. More recently, speculation around higher-than-expected growth (and the resulting prospect of further monetary tightening) has come back to the fore.
Although growth expectations have continued to pick up, we believe that the risks are tilted towards slowing growth – and moreover that current valuations in credit markets broadly underestimate this risk. As it stands, we don’t believe that credit spreads have fully priced in the risk of recession yet. Within investment-grade corporates, we believe that spreads are not currently pricing in sufficient risk premium despite the recent rally for cyclical sectors. And high-yield credit valuations in particular are stretched relative to those of higher-quality credit bonds, with current spreads below historical averages and offering little room to absorb too many more negative economic surprises, in our view.
When recession strikes—which we expect to occur in the US late this year—as profit margins erode and increasing numbers of corporate issuers refinance at higher rates than they have been accustomed to paying on debt in recent years, credit risk will likely increase. This would cause a shakeup in credit markets, prompting a boost in demand for bonds at the upper end of the credit quality spectrum at the expense of lower-credit-quality instruments.
The big implication for investors in active credit bond funds is that in this scenario, we would expect to see greater price dislocation in the credit market. In other words, more credit bonds will diverge from their fair value, some offering attractive value opportunities to take overweight positions relative to the benchmark, others representing ones to avoid (or underweight).
We are already observing these dislocations opening up in a number of sectors across the global credit universe. For example, in terms of underweights, real estate investment trusts (REITs) specialising in retail and office properties stand to lose out disproportionately as a result of the higher interest rate environment. Furthermore, the supply-demand dynamics of this part of the industry could be hard-hit during a recession. Similarly, we see the automotive sector as one of the potential losers in a downturn scenario, and carmakers face the added pressure of ongoing supply-chain disruption which began in the aftermath of the Covid-19 pandemic and are yet to fully resolve3.
Among overweights, banking is a sector which typically benefits from higher prevailing interest rates, and we see particular value in European banks, though—as highlighted by the US Federal Reserve’s recent emergency intervention to shore up the US banking sector—we are wary of asset-quality risk. We also see interesting opportunities in the food and beverage sector, although here persistent inflation pressures could eat away at issuers’ margins. Overall, given the potential risks ahead, we are conservative in our active positioning based on these views, with a bias towards higher-quality, defensive sectors.
Attempting to time macroeconomic shifts is notoriously challenging—even for professional active bond fund managers—and in the current environment, getting broad directional calls correct arguably has an even lower probability of success than usual.
Amid the burgeoning dislocation we are observing in credit markets, taking a bottom-up approach to security selection in managing active credit has a distinct advantage, not least in that it typically exposes investors to a much lower risk of large drawdowns4. And as central banks unwind years of quantitative easing, taking into account the shifting technical backdrop that this creates—which is a core part of our approach to managing active bond funds—is also becoming increasingly important in generating alpha in fixed income.
Our active bond funds managed in-house
Vanguard Emerging Markets Bond Fund
Vanguard Global Credit Bond Fund
1 Source: The average yield-to-worst of the Bloomberg Global Aggregate Credit Index was 5.12% as at 28 February 2023.
2 Source: Bloomberg as at 28 February 2023. The average dividend yields of the STOXX Europe 600 Price Index EUR, the MSCI Emerging Markets Index and the S&P 500 Index were 3.37%, 3.16% and 1.75% respectively as at 28 February 2023.
3 Source: Vanguard.
4 Source: Vanguard.
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