Vanguard's active fixed income funds employ a collaborative investment process centered around the portfolio management team. Portfolio managers are supported by teams of sector specialists, analysts, traders, risk managers, and others. How does this collaborative process work—especially during a challenging time for the bond markets such as the past year and a half? We asked Daniel Shaykevich and Brian Quigley, co-managers of Vanguard Core Bond Fund.
1. First, at a high level, can you explain how Vanguard portfolio managers build active bond portfolios?
Daniel: Good portfolio construction is all about finding the right balance between top-down and bottom-up risk-taking, with a lot going on in the middle. Top down is about managing risk and understanding the macroeconomic background. Bottom up is about maximizing the alpha from security selection, which can provide a performance tailwind regardless of the macro environment. Our teams are working hard to select the right instruments, whether it's the right bonds on the credit curve or the right coupons on the mortgage stack.
In the middle is where the cross-sector collaboration takes place. We combine the insights from our sector teams with our macro view, looking for the sector-level relative value. We work to identify which sectors are priced more attractively than others at any given time, which ones have less tail risk, and which ones have more upside.
We carefully consider opportunities across both rates and credit, as well as how our sectors interact with each other. We execute on these views to create a portfolio with the right mix of uncorrelated risk factors, sector exposures, credit quality, duration, curve positioning, and so on. All decisions are made in the context of their contribution to the broader portfolio and not just to their sector. Ultimately, this kind of collaboration and strategy discussions allow us to identify the best value on behalf of our investors.
2. Before we go too far, can you explain what you mean by rates and credit to a layman like me? I hear a lot about Vanguard's credit and rates specialists, but I'm not sure what the demarcation line is between the two.
Brian: It's really one Vanguard active taxable fixed income team. Both rates and credit experts work closely together throughout the investment process. However, we value deep specialization, and we are divided by sector teams as well. The rates specialists are generally focused on those sectors that are particularly sensitive to the direction of rates and the shape of the yield curve. Think mortgage-backed securities [MBS], inflation-protected securities [TIPS], and Treasuries.
Daniel: Obviously, by extension, the credit specialists focus on those sectors more driven by the perception of default risk, such as corporates or riskier sovereign bonds. Credit investing generally has far more downside risk than rates investing, but you get compensated for that risk with higher rates.
Got it. Brian, I think you were about to say something before I interrupted.
Brian: On Dan's point about the decision process, I was just going to add that oftentimes the bottom up informs the top down. Having sector specialist teams as deep and well resourced as ours is a huge advantage.
Oftentimes the bottom up informs the top down. Having sector specialist teams as deep and well resourced as our is a huge advantage."
Brian Quigley
Portfolio Manager
Before the pandemic really hit the U.S., the markets were responding to the risks at different speeds. In the Treasury market, for instance, we started to see widening spreads between older, less liquid issues versus newly issued Treasuries. When spreads are widening out like that, it's a sign of stress, and it was happening in Treasuries before the credit markets fully priced in the risk. The MBS market was also early. That sector started exhibiting signs of stress before valuations in the credit market had fully repriced. Both sectors provided us an early indication of the type of stress that was about to hit the rest of the market in the coming weeks.
With our collaborative approach, that information on the ground floor flows upstream quickly, informing the big top-down view. You may not have realized what was going on on the ground floor, but with this collaborative approach, that type of information flows up to the work stream pretty quickly. We were able to act nimbly, and if you look at the way we performed last year during the pandemic, this type of information flow was critical in being able to turn the portfolio around as quickly as we did, going into the pandemic and coming out.
3. You were remarkably perceptive in 2020. So far, 2021 seems more challenging for fixed income managers than 2020 in other ways.
Daniel: The market has been very challenging the last several months, even if you have a pretty clear view of the risks ahead. Eventual [monetary and fiscal] policy normalization will be disruptive, not just for fixed income but also for equity markets. It's a matter of how much and when. The level of monetary support is likely to remain high for a long time. With so much liquidity in the markets, assets across the fixed income spectrum remain in high demand, and we sometimes worry that the markets are struggling to price in some of the risks ahead.
Somewhat counter to the market consensus, we think the downside of the near term is much more limited for high-quality credit assets, even though on paper they tend to be more rate sensitive than the weaker, more levered parts of the credit market, such as high yield. That's where a repricing of real interest rates can have a meaningful impact on valuations—and where a lot of investors have been hiding, thinking that being in risky assets actually protects them from rising rates.
We have focused our underweights on those weaker parts of the credit spectrum. The portfolio's overall credit exposure is running a bit closer to neutral than typical. We have a variety of hedges that are designed to protect us from some of the volatility if the eventual withdrawal of monetary accommodation starts sooner rather than later. For example, we are using options strategies designed in conjunction with our credit derivatives team, which is composed of members of different trading desks in different sectors.
Disruption creates opportunity, and opportunity is where you make a lot of money. We had a very strong year in 2020 because of all the disruption. This year we're doing okay, outpacing the benchmark and on track to hit our alpha targets, but we're not having the same level of alpha generation as in 2020. The opportunities have been modest compared with last year, and some may not be worth the risk.
As we hopefully continue to move on from COVID, the economy and the policy mix will change, and volatility should pick up as the markets adjust to new realities. How we position ourselves into the next volatility spikes will determine whether we can make a little money or really outperform.
4. I'm trying to picture what happens when there's disagreement among you two or across teams. Can you give me an example where you didn't see eye to eye?
Daniel: A good recent example is our rates strategy, where I've been looking to get our short duration position even shorter, and Brian was rightfully concerned about the market positioning and the inability of the market to move quickly to higher yields. I was more focused on the longer-term threat of higher rates, both to the credit markets and overall. Brian was on the money in terms of the supply-demand dynamics of the Treasury market, while I was looking to get into a trade too early.
Brian: There was a lot of uncertainty around the recovery and how the Fed would react, which was going to take some time for the market to figure out. Meanwhile, expectations for growth and inflation had gotten quite high, and the rates market priced in a lot of that optimism. Positioning got quite one-sided, and it was going to be difficult to exceed expectations. Even though data was really strong, everybody was already short duration, so there was really nobody left to sell Treasuries or sell rates.
Dan saw the economic situation evolving and wanted to respond to that. My urging was that we should wait until the deck was cleared in terms of positioning and expectations and look for a better opportunity later to shorten duration.
Daniel: If you get into the right trade at the wrong time, it can be the difference between losing money and making money.
If you get into the right trade at the wrong time, it can be the difference between losing money and making money."
Daniel Shaykevich
Principal, Senior Portfolio Manager
Brian: We suggested that being underweight MBS would actually be a better, alternative way to structure the portfolio. That could work out in multiple scenarios, as opposed to being short duration, which would only work out when rates go higher. And so instead of going maximum short duration, we went underweight MBS. That trade worked out well, and MBS underperformed as rates declined. We were able to monetize the underweight to MBS and then scale into the short duration position. Our level of specialization allows us to recognize where opportunities present themselves and to find optimal ways to structure strategies.
5. This situation worked out, but what if you can't settle differences of opinion?
Daniel: Ultimately, there are certain areas of expertise where I'm going to be the stronger voice, mainly credit investing, and there are going to be other areas of expertise where Brian's going be to the stronger voice, mainly rates investing.
We bring different things to the table. Brian brings a massive amount of expertise in interest rates, Treasuries, the mortgage market, and the rate-sensitive products in the portfolio. My investing background is in emerging markets, and I still manage our top-performing emerging-market debt funds.* This gives me a global perspective. Emerging-market investors have been trained to recognize regime changes and trends through multiple cycles in multiple countries. These types of regime changes don't often happen in the U.S.—but sometimes they do.
Brian: Our disagreements are often around the edges and how we assign different probabilities to different scenarios. But those differences of opinion force us to consider other possibilities besides our central base case and ultimately lead us to construct a stronger portfolio.
6. So you don't have to resort to fisticuffs to resolve differences?
Brian: Ha—no, this isn't a Hollywood movie. We know and respect each other's strengths within and across teams.
Daniel: If it ultimately came down to irreconcilable differences, there is a management structure here that we can resort to.
Brian: I can't think of any example where we were on polar opposite ends in our views on how to structure the portfolio. We're focused not on one scenario outcome but rather a distribution of possible scenarios, and that's where it's actually very helpful to have different views. Our conversations are ongoing and fluid, and it's not just between me and Dan but across teams and with other portfolio managers, cross-pollinating ideas.
Daniel: We don't want drama on the trading floor or in the portfolio. We're good stewards of our clients' assets, working hard to add value through the cycle without losing focus on risk management.
Thank you for your time, gentlemen.
Daniel: You're welcome.
Brian: Pleasure.
* For the three-year period, Vanguard Emerging Markets Bond Fund Admiral™ Shares (VEGBX) outperformed 99% of funds in its category. Number of funds in category: 229. All data as of June 30, 2021. Results will vary for other time periods. Only funds with a three-year history were included in the comparison. (Source: Lipper, a Thomson Reuters Company.) Note that the competitive performance data shown represent past performance, which is not a guarantee of future results, and that all investments are subject to risks. For the most recent performance, visit our website at http://www.vanguard.com/performance.
Notes:
- For more information about Vanguard funds, visit institutional.vanguard.com or call 800-523-1036 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
- All investing is subject to risk, including the possible loss of the money you invest. Investments in bonds are subject to interest rate, credit, and inflation risk.
- Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
- Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.
- High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings. U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.