A conversation with Vanguard's bond chief

November 27, 2018

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John Hollyer

John Hollyer

In April 2019, John Hollyer will mark 30 years with Vanguard. He's spent many of them in our Fixed Income Group (FIG), which he has led since 2017, following stints as a taxable money market and government bond portfolio manager and after having started our investment unit's Risk Management Group.

A self-described "professional worrier," Hollyer is animated when talking about his global team of more than 175 investment professionals. Here he discusses markets and the economy, FIG's operation, and active management.

Is the yield curve likely to invert during the current cycle of Fed policy tightening?
A fair amount of economic history tells us that yield curve inversions are closely associated with and often followed by recessions. The curve has flattened a lot with the Fed's normalization of monetary policy. Inversions are signs of when the Fed felt that the economy was overheated enough that it needed the strong message of restrictive monetary policy to bring inflation risk into balance with their long-term objectives. I don't sense that the Fed feels that now. They have said they want to have a symmetrical approach to inflation, meaning they would allow it to be a little above or a little below their 2% target. Does the Fed feel a strong motivation to make policy restrictive enough to materially slow the economy? I think the answer to that is no. And if the answer to that is no, then I don't expect the yield curve to become inverted.

Is inflation in the United States a meaningful risk?
We don't see it as a material risk right now. It's a tail risk. More specifically, we expect inflation to rise marginally and then roll over. Using the Fed's favored core PCE index, our economics team is forecasting that it will get a bit above 2%—to 2.2% or 2.3%. That's engendered by things like the stimulus from the tax reform package, which is expected to dissipate after a year or two. The cyclical upswing will roll over as longer-term trends around globalization, technology, and demographics exert downward pressure on inflation. We expect it will converge back down toward the Fed's target of 2% and maybe wind up a little bit below it.

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What have we done recently to enhance our approach to bond trading?
Increasingly we're using tools to essentially scrape data from electronic sources and give our traders consolidated views they can use to more quickly ferret out bonds that will be good for our portfolios, letting them focus on the more challenging and value-adding opportunities. We're always pursuing better execution. There's also a big payoff there, because we're trading hundreds of billions of dollars in securities.

Our foreign exchange team, for example, trades a gigantic volume of currencies and has been innovative in adapting algorithmic trading tools that were developed in the equity market. We estimate that the team saved our clients more than $30 million in market impact costs in 2017. We've applied similar concepts to our derivatives trading team and now the most liquid sectors of the bond market. The challenge with measuring execution is that you can only execute a trade one way. You can't go to a parallel universe and see what your performance would have been if you had done it another way. So we can only estimate the effect of our progress, but it's real.

What fixed income capabilities have we added or bolstered most recently?
We've successfully completed the build-out of a top-notch emerging markets investment team. We have a fund in the public domain, the Emerging Markets Bond Fund, that's been out for about two years. Past performance is no indication of future return, but it's performed really well. The team, eight-plus people around the world, is doing a great job. And their insights get applied to a variety of our active credit portfolios.

We're in the process of developing a high-yield capability. We've hired a portfolio manager and several experienced analysts. Our active credit portfolios have freedom to go up to 5% high yield. We've used that capability sporadically in the past. We feel like now we're going to use it more effectively.

We've increased our quantitative analytical capabilities in our collaboration with our Risk Management Group, and that's bolstering our mortgage investment capabilities. We're also bolstering our global active rates investment capability. We've hired an active portfolio manager for interest rates in London. Last year we hired a global rate and foreign exchange strategist.

How do you advise institutional investors to think about the active-passive decision in fixed income?
The key is not active versus passive, it's low cost. And there's lots of opportunity for low-cost active to add value. Our approach to active is geared around having a well-developed and deep team that can add value a variety of ways. We employ a hub-and-satellite portfolio management strategy. The hub is our senior strategy group, which establishes our outlook and investment policy, including broad, credit-specific, and rate-specific risk budgets. By empowering satellite teams to go really deep in their sectors, we get a lot of bottom-up selection strategies that are the engine of value creation that we try to harness across the portfolios. We also maintain a high focus on risk management, typically taking more disciplined swings in risk than our competitors, who have to take bigger swings to cover their high fees.

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We want to provide exposure to the market return to our clients, and we employ active strategies around that. Because of our cost advantage, we're probably not going to push as hard on the active strategy risks, which we think will give us a more consistent outcome and potentially lower drawdown or tail risk.

How does your team add value in our actively managed portfolios? 
We look for allocation opportunities, whether that's longer or shorter interest rates or more or less overweight or underweight credit exposure or various mortgage strategies or different countries. The allocation that we're comfortable with today is being overweight credit but not full overweight. The economy and credit conditions are strong. We believe the Fed is at least six months away from beginning to have a restrictive monetary policy. We're not fully overweight credit risk, because the valuations in credit are high—the spreads, the extra income you get are low by historical standards.

In credit, we have a strong capability in subsector allocation and selection. And there's a lot of breadth. We're able to independently exercise our judgment there literally hundreds of times, which typically is an engine for our value-add for our clients. That engine's always running.

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How do you manage a large team that's spread around the world?
We are truly global. We've got people around the world collaborating in a cycle of processes that result in our investment outcomes. It is a challenge to manage globally, because the complexity goes up. You can't do it without a great team, including a high-performing leadership team. That means things like being frank and accountable with each other and analyzing and prioritizing activities so we focus on the right things.

The intentional effort that Vanguard's put into developing leaders has been really important. We know our people managers are deep investment experts; they've spent their whole careers developing those skills. But we also need to develop them as leaders. And I think that differentiates Vanguard from a lot of investment organizations, where it's all about the ability to invest. In many firms, the deepest expert gets made the boss, even if he or she is a lousy boss and there's no accountability for being a good boss. Vanguard said we want both. We want you to be great investors—our clients are depending on that—and we want you to be great leaders, because you can't sustain a big complex organization without great leaders.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss.
  • Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.