(Bloomberg) — The Federal Reserve’s slower path to cutting interest rates offers a greater opportunity to lock in attractive returns for longer, and investors should “right-size” their allocation to bonds versus stocks, Vanguard Group Inc. said.
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Policymakers left interest rates unchanged on Wednesday and Fed Chairman Jerome Powell maintained hopes of a rate cut this year but avoided giving a timetable for a cut. Persistent inflation is likely to make the Fed cautious in the near term, and the hurdle for further rate hikes is high, Vanguard’s fixed income team led by Sara Devereux wrote in a note obtained by Bloomberg.
“All eyes are looking for signs of a clearer inflation trend,” the team wrote. “Higher market volatility should provide more opportunities for our portfolios.”
The world’s second-largest asset manager, which manages $9.3 trillion globally, sees the potential for better risk-adjusted returns for bonds than stocks over the next five years. The environment for fixed income credit sectors remains favorable, fundamentals remain largely stable and demand from all-in yield buyers is strong, said the team, which also includes Chris Alwine, Roger Hallam and Paul Malloy.
Investment-grade bond risk premiums, or the additional premium over U.S. Treasuries that investors receive for holding riskier debt, are close to levels last seen in November 2021.
“We expect this tailwind to continue in the second quarter,” wrote Devereux and her team. “We are coming off the biggest wave of emissions of the year, which will constrain supply as demand should remain steady or increase.”
Citing Taylor Swift’s Eras Tour, Vanguard announced a new era for fixed income in October and recommended loading up on investment-grade bonds. In November, bonds posted their best monthly returns since 2008 as economic data suggested the Fed may be ready to raise interest rates.
Last month, the asset class posted its worst performance on a total return basis since September as traders scaled back their rate cut expectations.
Potential problems
The asset manager sees a low probability of a US recession in the near term, even if policy is restrictive, which usually carries the risk of a further economic slowdown. According to Vanguard, there is scope for spreads to widen if economic conditions deteriorate, whether due to higher inflation or slower growth.
The window to take on more credit risk is between late October and mid-April, the investment firm said. With upside surprises in inflation data and credit valuations now less convincing, Vanguard has reduced credit risk across all sectors – particularly in emerging markets and among companies with lower credit quality – and increased quality.
The company prefers shorter-dated bonds from the financial sector and BBB-rated bonds from industrial companies.
“We like the relative value of shorter-dated bonds where spread levels appear favorable,” they wrote. “We also value the opportunities in the European credit sector. The reviews are more convincing than in the USA.”
In high yield, BB and B rated bonds offer attractive yields, but the potential for further spread tightening is limited. Vanguard said it sees opportunities in the lower-quality and stressed parts of the market and considers high-quality bank loans attractive.
Mortgage-backed securities spreads remain in the middle of the company’s fair value range and Vanguard sees better opportunities in certified collateralized mortgage notes, select specified pools and agency commercial mortgage-backed securities.
Additionally, the long end of the curve offers the best value in higher-rated municipal bonds, while the opportunities in lower-quality municipal bonds are best at the short end.
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