After a lousy year for bonds in 2022, the outlook is better. So much better that Sara Devereux, global head of the fixed-income group at Vanguard, has taken to sporting a button around the office declaring, “Bonds Are Back.”
“I haven’t seen this kind of opportunity in a long time, after a decade of yields at the zero lower bound,” says Devereux, whose unit has more than $2 trillion in assets under management.
Vanguard is the world’s second-largest asset manager, with $7.7 trillion in assets under management. In bonds it is best known for index funds. But it is also one of the biggest providers of U.S. active bond funds, with $890 billion in assets, and Devereux is helping lead the charge in active management.
Devereux joined Vanguard in 2019 from Goldman Sachs, where she spent more than two decades specializing in mortgage-backed securities and structured products. This year, she was recognized by Barron’s for the second time as one of the 100 most influential women in U.S. finance.
Devereux spoke with Barron’s on May 24 about the outlook for the U.S. economy and inflation and where she sees opportunities now. An edited version of the conversation follows.
Barron’s: Where is the U.S. economy heading?
Sara Devereux: We believe we’re going have a shallow recession later this year. That was our view at the beginning of the year, and it remains our view. We’re not calling for a hard landing.
Inflation has fallen from its peak, but is still too high for comfort. Where to from here?
The war on inflation isn’t over. We made progress from approximately 9% to 5% in the consumer price index. Our outlook is that core PCE [the core personal-consumption expenditures price index] will end this year at 3.3% and, by the end of next year, will be in the low twos.
Most of the progress has been on the supply side: goods disinflation as supply-chain disruptions were resolved. That’s great, but we need to see the demand side cool, in particular wages and the labor market. That has a large impact on stickier service prices. This is what the Fed is focused on, and that shoe has yet to drop.
The labor market has been cooling, but it remains tight. Earlier this year, there were two jobs available for every unemployed person who wanted a job. That ratio has dropped but is still at 1.8 and needs to get closer to 1:1. That is the core of what the Fed needs to do: cool the labor market so that those excess job openings close, but try to not overshoot into layoffs and a deep recession. That is a difficult needle to thread.
The labor market is a lagging indicator, and when it cracks, it tends to move sharply. That dynamic is at the heart of our outlook for a shallow recession. Historically, when unemployment spikes in a recession, half of it is attributable to layoffs, or fewer job openings, and the other half from people entering or re-entering the workforce and not finding a job right away. This time is different in that we don’t foresee labor-force participation increasing the way it has historically. This is due to demographics and multiple other things. But it effectively puts a lid on unemployment rising past 5%.
To get inflation down, the Federal Reserve will have to continue its fight and put us through a shallow recession.
Should the Fed hike interest rates again in June, or pause?
Our view is that the Fed will pause in June to assess the impact of restrictive policy on inflation and the labor market, but monetary policy has long and variable lags, and a lot of tightening went into the market in a short amount of time. It’s very difficult to predict when those tighter financial conditions will bite.
Our base case is that the Fed will hold rates in restrictive territory for the remainder of the year because we think that is necessary to slow the economy and cool the labor market in particular. That in turn will cool inflation. We don’t believe the Fed is going to cut rates later this year, as the market does.
Vanguard calls periods of economic uncertainty and market volatility Vanguard weather. How is the forecast looking?
As someone who has been in fixed income for 25 years, I see a ton of opportunity if you are working with the right manager. An environment like this plays to our strengths and bodes well for active [management]. Volatility drives dispersion in valuation, and more dispersion means more opportunity to monetize that relative value. When everything is trading at the same level and there is no volatility, there is no opportunity to capture value outside of the index.
Volatility can also drive periods of dislocation where valuations overshoot. The Silicon Valley Bank crisis earlier this year is an example. A good active manager will have dry powder to deploy. We are headed into a recession, and credit risk is rising. This is where our best-in-class credit teams can differentiate by picking the right names. There are a lot of yields to be had in sectors such as corporate credit.
Where else are the opportunities?
Given our economic forecast, we favor a high-quality tilt. That’s Treasuries, municipal bonds, and investment-grade [securities]. But there is also an opportunity in riskier parts of the market—high yield and emerging markets—where we are going to have a selective approach.
We are finding that investors are focused on four areas, from the lowest risk profile to the highest. First, we have seen strong inflows into our money-markets funds. That’s not surprising, as yields are attractive and there have been outflows from bank deposits where yields are lower. Yields are higher because the yield curve is inverted, and it is attractive to put your money in a money-market fund if you have a short investment horizon. It is a great place for cash for three to six months.
If you have a longer horizon, you might be better off further up the yield curve. That way you can get some yield, but also duration that could rally, especially if we have a recession.
What is the second area attracting investors?
The second area where we are seeing a lot of flows is into our Treasury funds and exchange-traded funds. Again, yields are attractive. This time last year, to get 4% you had to go into high yield or private credit. Now, you can get 4% in U.S. Treasuries, which are backed by the “full faith and credit” of the federal government and are highly liquid.
“There is a lot of yield to be had in corporate credit, with 5.5% to 6% in investment grade and 8% to 9% in high yield.”
Another reason that people like Treasuries, and why we like them, is they are the purest diversification play if you have a portfolio heavy in equities. If we’re headed into a recession, typically these bonds will rally, but it also means credit risk is rising, which means corporate bonds can lag behind Treasuries in a rally. Corporate bonds will have more correlation to the equity market.
The sweet spot is the intermediate part of the Treasury curve, say five years, but it depends on your time horizon. Whatever your investment horizon is, your fixed-income fund should have a shorter horizon. One example is the Vanguard Intermediate-Term TreasuryVGIT –0.26% ETF [VGIT].
The third area where we are seeing good flows is municipal bonds. Last year, the muni market saw record outflows because investors had the unique opportunity to tax-loss harvest [sell losing stock positions to offset taxable gains]. That selling drove an overshoot in valuations to the cheap side. And this was in stark contrast to the fundamental value, which is strong: Over 70% of muni debt is rated AA or higher.
In March, we launched the Vanguard Short-Term Tax-Exempt Bond [VTES], a municipal-bond index ETF for investors with a short-term time horizon and low interest-rate risk tolerance.
And the fourth?
There is a lot of yield to be had in corporate credit, with 5.5% to 6% in investment grade and 8% to 9% in high yield. We strongly recommend leveraging an asset manager. Waters are going to be choppy heading into a recession. All boats won’t rise with the tide, and it will be critical to pick the right companies to invest in because avoiding the losers can be just as important as picking the winners.
Within corporate credit, we have a high-quality tilt. In investment grade, we are biased for higher quality, which we define as earnings stability. We are in sectors such as pharma, healthcare, utilities, the large-cap banks, noncyclical over cyclical.
The Vanguard Core BondVCOBX +0.50% fund [VCOBX] and Vanguard Core-Plus BondVCPAX +0.41% fund [VCPAX] offer an easy way for investors to get diversified exposure to high-quality bonds. They are mostly investment-grade bonds with some high yield and emerging markets sprinkled in. In the Core-Plus fund, the managers have a bit more flexibility to add risk when market conditions are favorable.
Earlier this year, we launched the Vanguard Multi-Sector Income BondVMSIX +0.23% fund [VMSIX] which has exposure to investment-grade securities, high-yield corporate securities, and emerging markets debt.
How should investors think about high yield and emerging markets?
You should consider funding both out of the equity part of your portfolio because they have higher correlation to equities. These are going to be attractive versus equities, with 8% to 9% yields right now. But you need to be selective.
In high yield, we are cautious based on current spread valuations. However, all-in yields are attractive, so it’s important to be selective. We are biased toward the higher-quality segments, specifically the double-B and B-rated categories. With respect to sectors, we see opportunities in food and beverage, paper and packaging, healthcare, and other noncyclicals. We see a lot of opportunity in security selection. Our teams utilize an up-in-quality bias and focus on bottom-up security selection.
Also within high yield, we prefer bonds over loans, particularly bank loans from issuers that are loan-only, which are lower-credit-quality issuers. The floating-rate nature of that debt has their funding costs going higher, which could cause some stress. You have to go company by company and look for strong balance sheets and cash flows.
