A new era for bonds

2024 is set to be a banner year for bond investors, with attractive yields and the potential for capital appreciation from declining rates fuelling new inflows into the asset class.

Although Vanguard economists expect interest rate cuts in late 2024, higher real (inflation-adjusted) rates are likely here to stay for the next decade, meaning higher expected long-term returns and a new era for fixed income. 

Adding active fixed income to investor portfolios

Bond index funds and ETFs are a great starting point for fixed income allocations, but actively-managed strategies offer the potential for higher levels of return for investors willing to take additional risk.

For these investors, active bonds funds can offer a compelling addition to core fixed income allocations. Compared with equity markets, the global investable fixed income universe is much larger, providing greater opportunity for active bond managers to identify and add value. Unlike indexed investment strategies that aim to match the performance of a benchmark, active bond fund managers can capitalise on market misspricings while managing their level of risk in both rising and falling markets. 

Higher volatility breeds opportunity 

Despite the positive outlook for bond markets in 2024, it’ll unlikely be all smooth sailing ahead for investors. Although volatility levels have been declining, we expect they will rise above normal in the months ahead  – and with higher volatility comes greater dispersion  in security performance. Active managers can aim to capitalise on this dispersion to deliver excess returns to their investors.

Choppy waters ahead:  Volatility is expected to move higher 

Source: Bloomberg. The chart shows the historical weekly average values of the Chicago Board Options Exchange Volatility Index, or ‘VIX’, over the last ten years (20 December 2013 to 20 December 2023). The VIX is a popular measure of the market’s expectation of volatility based on S&P 500 index options.

As we enter a potentially more uneven economic environment in the months ahead, security selection will play an even more critical role in driving returns. Against such a backdrop, investors can benefit from the added value offered by active managers with access to experienced research teams providing deep levels of fundamental analysis on each individual company going into their fixed income portfolios.

An asymmetric advantage

In addition to being backed by a seasoned team of credit research analysts, our active fixed income managers benefit from other key advantages. Vanguard’s focus on lower costs allows our investors to keep more of their returns‒ but importantly, our lower fees also influence how our active managers approach risk. While some active managers can feel pressured to maintain higher risk in their portfolios to offset their higher fees, our lower costs mean our managers can afford to be more discretionary in their approach - giving them an asymmetric advantage over their peers.

This doesn’t mean we necessarily take less risk than other actively-managed bond funds. But it does mean that we are more discretionary in our risk-taking. For example, when the risk/reward trade-off is attractive, we can take the same level of risk as our competitors – and we often do. But when we believe the trade-off is not enough to compensate for the risks on the horizon, our advantage is that we have the optionality to be patient, remaining on the sidelines until the situation improves or better opportunities evolve. 

This asymmetric advantage puts us in a favourable position to navigate the uncertain economic climate over the coming months. If recession hits, our fund managers can reduce risk and be defensive; at the same time, they have the liquidity to take positions when market dislocations and mispricing opportunities occur ‒ often when other managers cannot afford to do so.  

In other words, we aim to do just as well as our competitors in the good times but better in the bad times. Further, our commitment to offering ‘true-to-label’ products means our active bond funds have a similar risk and asset-class profile to the assets they represent, but with the flexibility to add value while staying true to the character of the asset class.

¹ The US bond market is estimated to be worth approximately $53 trillion with more than 19,000 number of securities – compared to the US equity market’s estimated value of $40 trillion and 2,300 number of securities. Source: Vanguard, Bank of International Settlements and Bloomberg USD Multiverse Index.

² When dispersion increases, there is less unilateral behaviour in security performance and a greater chance of individual securities deviating from their fair values.